The new ASC 606 Revenue Recognition standards have sunk their hooks into almost every industry—requiring businesses to analyze and amend their policies in order to comply. Due to inadequate accounting scrutiny given to certain collaboration agreements, businesses in the life science industry may think that they will be able to coast easily through this implementation process. However, there are specific factors within ASC 606 that apply directly to the aspects of contracts with customers entered into by life science companies—and the application of the new revenue recognition is going to require a lot more effort than life sciences entities may have expected.
In order to ease the tension and complication of the ASC 606 enforcement, the following are a number of considerations that companies in the life science industry should recognize and examine.
Customer Contracts
In certain life sciences arrangements, a contract with a customer may be partially in the scope of the new revenue recognition standard and partially in the scope of other accounting guidance. If the other accounting guidance specifies how to separate or initially measure one or more parts of a contract, then an entity must first apply those requirements before adhering to the requirements set forth by ASC 606. Otherwise, the entity applies the new revenue recognition standard to initially measure the separately identified parts of the contract.
The new standard excludes from its scope contracts with a collaborator or a partner that are not customers. However, a contract with a collaborator or a partner is in the scope of this new standard if the counterparty meets the definition of a customer for part or all of the arrangement. Accordingly, a contract with a customer may be part of an overall collaborative arrangement, in which case, this new standard is applied to that part of the contract.
Clauses of Termination
In addition, contracts in life sciences may include clauses that allow the termination of a contract without penalty or a penalty that is not substantive. The contract length, performance obligations in the contract, and the timing of revenue recognition will be affected by lack of a substantive termination penalty.
If either party in an agreement has a unilateral enforceable right to terminate that agreement without compensating the other party, then a contract does not exist.
Identifying Separate Performance Obligations
Identifying the separate performance obligations within a contract can be challenging too. This process starts with identifying the promised products or services. Many entities within the pharmaceutical and life sciences industry provide multiple products or services to their customers as part of a single arrangement. For example, entities in life sciences will often perform manufacturing services in addition to the transfer of a license and performance of research and development (R&D) services.
Different conclusions may be reached on the identification of distinct promises based on the type of manufacturing performed. For example, if the manufacturing of active pharmaceutical ingredients (API) is performed in support of the underlying R&D services, vendors might be more likely to conclude that the promises are not distinct since the company cannot fulfill its promise to perform R&D independent from its promise to manufacture API. Conversely, manufacturing of an approved product in support of commercialization efforts is more likely to result in a distinct promise if the manufacturing is not complex or specialized such that another party could perform the services.
Significant Future Reversal Probability
The amount of consideration that an entity expects to be entitled to for transferring products or services to a customer may be variable because of price concessions, volume discounts, rebates, and returns. To estimate any variable consideration, the entity can use either the expected value method (i.e. a probability-weighted amount method) or the most likely amount method (i.e. a method to choose the single most likely amount in a range of possible amounts). The method selection is not a “free choice” and must be based on which method better predicts the amount of consideration to which the entity will be entitled. The entity must apply one method consistently throughout the contract, consider all information (historical, current, and forecast) that is reasonably available, and identify a reasonable number of possible consideration amounts.
Conclusion
The life science industry must pay close attention to the rules and regulations set forth by ASC 606. Although there are many more factors to consider, analyzing customer contracts and clauses of termination, identifying separate performance obligations, and determining future reversal probability are some of the most pressing issues that life science businesses must acknowledge in order to comply with ASC 606.
