For life sciences companies, revenue recognition is a Critical Accounting Policy
• Multiple Element Arrangements - in accounting, certain contracts have multiple elements recognized separately based upon standard revenue recognition guidance.
• Upfront Fees - life sciences licensing with a one-time, non-refundable, up-front fee and how the revenue should be recognized.
• Life Sciences Product Sales - records to support assumptions and calculations of these sales deductions
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Revenue Recognition Subtleties & Pitfalls For Life Sciences Companies
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Spring 2006
John Pennett CPA, Partner
Director, Life Sciences Practice
By now, most life sciences company CFOs and Controllers should be
fully aware of the primary revenue recognition criteria as established
by the Securities Exchange Commission (SEC). And we all realize that
revenue recognition continues to be a Critical Accounting Policy for
all companies. In the SEC's Staff Accounting Bulletin (SAB) 101/104,
the commission established the four major criteria for revenue recognition,
which are: that persuasive evidence of an arrangement exists, delivery
has occurred or services have been rendered, the seller's price is
fixed or determinable, and collectibility is reasonably assured. While
everyone has adopted this guidance, there are countless other accounting
pronouncements which govern the manner in which revenue should be
recognized. The subtleties of revenue recognition, critical to any
organization's financial reporting, are dependent upon many factors,
including the industry in which the company operates. The following
are highlights of revenue recognition subtleties that affect the life
sciences arena and can frequently be overlooked.
Multiple Element Arrangements
In accounting, certain contracts are deemed to have multiple elements.
The current accounting literature requires that such elements are
separated and recognized separately based upon standard revenue recognition
guidance. A common example of this type of an arrangement can be found
in licensing agreements, where companies will license compounds or
products, provide for clinical support agreement, and provide for
a royalty stream once approved for commercialization. When all of
these revenue streams are combined into one, for accounting purposes
they must be separated. The difficulty results from the requirement
to recognize each element at its "fair value", which may or may not
be consistent with the explicit licensing terms. Further, developing
documentation to support these "fair values" is often difficult given
the uniqueness of each licensing agreement, although there are some
industry norms which may provide guidance.
Upfront Fees
Many times in the life sciences licensing arena, organizations charge
a one-time, non-refundable, up-front fees. In accordance with Staff
Accounting Bulletin #101/104 by the Securities and Exchange Commission,
"up-front fees, even if nonrefundable, 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." In essence, if a company charges an up-front fee,
the revenue generated from this fee should be deferred and recognized
over the period of the average customer life.
Other milestone fees paid to the licensee are often recognized upon
successful clinical outcome, however, in certain instances, these
fees (even if non-refundable) may be required to be deferred if the
milestone payment is the subject of a multiple element agreement or
all of the revenue recognition criteria have not been met.
Product Sales
Sales of products in the life sciences industry are often subject
to deductions, which require quantification and recognition at the
time of sale. It is essential that companies maintain careful records
to support its assumptions and calculations of these sales deductions.
The principal areas where such deductions occur include:
- Chargebacks from wholesalers
- Rebate and discount programs
- Returns
The topic of channel stuffing has also received significant attention, thereby requiring companies to analyze whether very significant sales transactions are reflective of a completed economic transaction. To the extent the transaction is reflective of channel stuffing, the revenue may not be recognizable.
Conclusion
The accounting guidance surrounding revenue recognition is highly complex and requires diligent and careful analysis. The subtleties and pitfalls outlined above are only a few of the many areas that should be closely examined. Organizational management, including non-accounting personnel, should periodically review revenue recognition policies internally to ensure continuing compliance. It is also advised to consult with external accountants to review new contractual arrangements and modifications to existing arrangements to ensure proper revenue recognition.
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