US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 1

Chapter 1: Capitalization and Impairment

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1-2 Capitalization of internal development costs: timing – Scenario 2

Background

A pharmaceutical entity is developing a vaccine for HIV that was successful during Phases I and II of testing. The drug is now in the late stages of Phase III testing. It is structurally similar to drugs the entity has successfully developed in the past with very low levels of side effects, and management believes it will be favorably treated by the regulatory authority because it meets a currently unmet clinical need.

Question: Should management start capitalizing the development costs?

Solution

No. Costs to perform research and development, including internal development costs, should be expensed as incurred, regardless of past history with similar drugs or regulatory approval expectations.

Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

1-4 Capitalization of development costs for generics

Background

An entity is developing a generic version of a painkiller that has been sold in the market by another company for many years. The technological feasibility of the drug has already been established because it is a generic version of a product that has already been approved, and its chemical equivalence has been demonstrated. The lawyers advising the entity do not anticipate any significant difficulties in obtaining commercial regulatory approval.

Question: Should management capitalize the development costs at this point?

Solution

No. Research and development costs should be expensed when incurred.

Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

1-6 Development expenditure once capitalization criteria are met—Scenario 2

Background

Company A has developed a vaccine delivery device that has received regulatory approval. Company A is incurring costs to add new functionality to the existing device. The additional functionality will require Company A to receive regulatory approval prior to selling the enhanced device.

Question: Should Company A capitalize these development costs?

Solution

No. Company A should expense the costs of adding new functionality as incurred as these costs are research and development expenditures.

Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

1-8 Cost that qualify as research and development costs

Background / Question

Company A is developing a new compound for the treatment of pancreatic cancer. Company A is incurring costs to identify a new formulation and make a routine update to an existing manufacturing line that will be used to make the clinical trial product.

Question: Do the additional expenditures incurred by Company A qualify as research and development costs?

Solution

The cost associated with the identification of a new formulation would be expensed as research and development costs. Research and development costs could include materials, equipment or facility charges, compensation and benefits for personnel, intangible assets purchased from others (if they do not have alternative use or have not achieved technological feasibility), the cost of contract services performed by others and a reasonable allocation of indirect costs.

The cost associated with the routine update to the manufacturing line would ultimately be expensed to cost of sales.

Relevant guidance

ASC 730-10-25-1: Research and development costs… shall be charged to expense when incurred...

ASC 730-10-55-1: The following activities typically would be considered research and development within the scope of this Topic (unless conducted for others under a contractual arrangement…):

a.  Laboratory research aimed at discovery of new knowledge

b.  Searching for applications of new research findings or other knowledge

c.  Conceptual formulation and design of possible product or process alternatives

d.  Testing in search for or evaluation of product or process alternatives

e.  Modification of the formulation or design of a product or process

...

h.  Design, construction, and operation of a pilot plant that is not of a scale economically feasible to the entity for commercial production

i.  Engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready for manufacture

1-9A: Accounting for a payment upon regulatory approval (added August 2019)

Background

Company A acquired IP rights to a drug compound for an upfront cash payment of $25 million and agrees to make a one-time payment of $20 million if and when regulatory approval is obtained. There are no alternative future uses for the IP and the acquired asset does not constitute a business. Because the drug compound was acquired prior to regulatory approval, the upfront cash payment of $25 million is expensed as research and development costs.

Question: How should Company A account for the $20 million approval payment?

Solution

Assuming the cost is recoverable based on expected future cash flows, Company A would capitalize the $20 million payment upon regulatory approval as an intangible asset because the payment relates to what is now an approved compound. Company A would amortize the intangible assets over the useful life of the IP beginning on the date the asset is available for its intended use, which would generally be the regulatory approval date.

Relevant guidance

ASC 730-10-25-2(c): Intangible assets purchased from others. The costs of intangible assets that are purchased from others for use in research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be accounted for in accordance with Topic 350 [Intangibles – Goodwill and Other]. However, the costs of intangibles that are purchased from others for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred.

ASC 350-30-20: Intangible Assets - Assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.)

ASC 350-30-35-1: The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life shall be amortized; an intangible asset with an indefinite useful life shall not be amortized.

ASC 350-30-35-2: The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity...

1-11 Indefinite-lived intangible assets

Background

Management of a pharmaceutical entity has acquired an intangible asset that it believes to have an indefinite useful life.

Question: How should management account for the acquired intangible asset?

Solution

If none of the factors in ASC 350-30-35-4 limit its useful life, the asset should be considered to have an indefinite life. The asset would not be amortized, but would be tested for impairment annually and whenever there is an indication that the intangible asset may be impaired.

Pharmaceutical intangible assets that might be regarded as having an indefinite life could include acquired brands (e.g., over-the-counter products) or generic products. The limited life of patents means that prescription pharmaceutical products and medical devices generally would not have indefinite lives.

Relevant guidance

ASC 350-30-35-4: If no legal, regulatory, contractual, competitive, economic or other factors limit the useful life of an intangible asset to the reporting entity, the useful life of the asset shall be considered to be indefinite. The term indefinite does not mean the same as infinite or indeterminate. The useful life of an intangible asset is indefinite if that life extends beyond the foreseeable horizon—that is, there is no foreseeable limit on the period of time over which it is expected to contribute to the cash flows of the reporting entity...

ASC 350-30-35-15: If an intangible asset is determined to have an indefinite useful life, it shall not be amortized until its useful life is determined to be no longer indefinite.

ASC 350-30-35-16: An entity shall evaluate the remaining useful life of an intangible asset that is not being amortized each reporting period to determine whether events and circumstances continue to support an indefinite useful life.

ASC 350-30-35-18: An intangible asset that is not subject to amortization shall be tested for impairment annually and more frequently if events or changes in circumstances indicate that it is more likely than not that the asset is impaired.

1-13 Indicators of impairment – Property, plant and equipment

Background

Company A announced a withdrawal of a marketed product due to unfavorable post-approval Phase IV study results. Company A informed healthcare authorities that patients should no longer be treated with this product. Company A has property, plant and equipment that is dedicated to the production of the terminated product and has no future alternative use.

Question: What impairment indicators should Company A consider?

Solution

Company A should consider the general indicators given in ASC 360-10-35-21 when assessing whether there is an impairment of property, plant and equipment. In addition, pharmaceutical and life sciences entities should consider the following common industry-specific factors:

• Patent expiry date
• Failure of the machinery to meet regulatory requirements
• Technical obsolescence of the property, plant and equipment (for example, because it cannot accommodate new market preferences)
• Changes in medical treatments
• Market entrance of competitive products
• Declining sales (e.g., due to market demand, a product recall)
• Changes or anticipated changes in third-party reimbursement policies that will impact the price received for the sale of product manufactured by the property, plant and equipment.

Based on Company A’s determination that the property, plant and equipment dedicated to the production of the terminated product cannot be repurposed for other use, the long-lived asset group is likely impaired.

Relevant guidance

ASC 360-10-35-21: A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable...

1-15 Impairment testing and useful life

Background

Company A has a major production line that produces its blockbuster antidepressant. The production line has no alternative use. A competitor launches a new antidepressant with better efficacy. Company A expects sales of its drug to drop rapidly and significantly. Although positive margins are forecasted to continue, Company A identifies this as an indicator of impairment. As a result of the new competition, Company A may exit the market for this drug.

Question: How should Company A assess the impairment and useful lives of long-lived assets when impairment indicators have been identified?

Solution

Assuming that the antidepressant asset group represents the lowest level of identifiable cash flows, Company A should evaluate the carrying amount of the antidepressant’s asset group (including the production line) relative to its future undiscounted cash flows. An impairment loss should be recognized if the carrying amount of the antidepressant’s asset group exceeds the future undiscounted cash flows. The resulting impairment would be based on the difference between the carrying amount of the unit and its fair value.

Company A should revise the estimated useful life of the affected assets after the impairment analysis is performed based on the estimated period it expects to obtain economic benefit from the assets. After recognizing the impairment and revising the estimated useful life for the affected assets, Company A would continue to amortize the remainder of the asset over its expected useful life. However, regardless of whether there is an impairment recognized as a result of the impairment analysis, Company A should assess the useful life of the assets based on the estimated period it expects to obtain economic benefit from the assets and revise the useful life as necessary.

Relevant guidance

ASC 360-10-35-21: A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable...

ASC 360-10-35-17: An impairment loss shall be recognized only if the carrying amount of a long-lived asset (asset group) is not recoverable and exceeds its fair value. The carrying amount of a long-lived asset (asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset (asset group). That assessment shall be based on the carrying amount of the asset (asset group) at the date it is tested for recoverability, whether in use... or under development... An impairment loss shall be measured as the amount by which the carrying amount of a long-lived asset (asset group) exceeds its fair value.

ASC 360-10-35-22: When a long-lived asset (asset group) is tested for recoverability, it also may be necessary to review depreciation estimates and method… or the amortization period… Any revision to the remaining useful life of a long-lived asset resulting from that review also shall be considered in developing estimates of future cash flows used to test the asset (asset group) for recoverability…

ASC 360-10-35-20: If an impairment loss is recognized, the adjusted carrying amount of a long-lived asset shall be its new cost basis. For a depreciable long-lived asset, the new cost basis shall be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited.

1-17 Exchange of intangible assets when control of the nonfinancial asset is not transferred

Background

Company A is developing a hepatitis vaccine compound. Company B is developing a measles vaccine compound. Company A and Company B enter into an agreement to exchange the two products. The exchange of products will not involve the transfer of legal entity ownership interests. Company A retains an option to repurchase the hepatitis vaccine. As such, Company A will not lose and Company B will not gain control of the hepatitis vaccine compound. The fair value at contract inception of Company B’s compound is $3 million. The carrying value of Company A’s compound was zero, as it was internally developed.

Question: How should Company A account for the swap of vaccine compounds, assuming that the transaction has commercial substance?

Solution

Given Company A can repurchase the hepatitis vaccine (i.e., via the call option), Company A would not recognize a gain or loss on the transaction as control has not transferred to Company B (as defined in ASC 606-10-25-30(c)).

Company A would evaluate the exercise price for the option to determine the accounting treatment. If the exercise price is greater than or equal to the original consideration received for the hepatitis vaccine (i.e., the $3 million fair value of the measles vaccine), Company A would recognize a financing arrangement. If the exercise price was less than the original consideration, Company A would recognize the arrangement as a lease under ASC 840 (or ASC 842 as applicable). The accounting for repurchase arrangements associated with transfers of nonfinancial assets can be complex. Refer to PwC’s Property, plant and equipment guide, Section 5.4.4.3 for further details.

Relevant guidance

ASC 610-20-25-6: Once a contract meets all of the criteria in paragraph 606-10-25-1, an entity shall identify each distinct nonfinancial asset and distinct in substance nonfinancial asset promised to a counterparty in accordance with the guidance in paragraphs 606-10-25-19 through 25-22. An entity shall derecognize each distinct asset when it transfers control of the asset in accordance with paragraph 606-10-25-30.

ASC 606-10-32-21: To determine the transaction price for contracts in which a customer promises consideration in a form other than cash, an entity shall measure the estimated fair value of the noncash consideration at contract inception.

ASC 606-10-25-30: If a performance obligation is not satisfied over time in accordance with paragraphs 606-10-25-27 through 25-29, an entity satisfies the performance obligation at a point in time. To determine the point in time at which a customer obtains control of a promised asset and the entity satisfies a performance obligation, the entity shall consider the guidance on control in paragraphs 606-10-25-23 through 25-26. In addition, an entity shall consider indicators of the transfer of control, which include, but are not limited to, the following:

…

c.  The entity has transferred physical possession of the asset—The customer’s physical possession of an asset may indicate that the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset or to restrict the access of other entities to those benefits. However, physical possession may not coincide with control of an asset. For example, in some repurchase agreements and in some consignment arrangements, a customer or consignee may have physical possession of an asset that the entity controls. Conversely, in some bill-and-hold arrangements, the entity may have physical possession of an asset that the customer controls. Paragraphs 606-10-55-66 through 55-78, 606-10-55-79 through 55-80, and 606-10-55-81 through 55-84 provide guidance on accounting for repurchase agreements, consignment arrangements, and bill-and-hold arrangements, respectively.

ASC 606-10-55-66: A repurchase agreement is a contract in which an entity sells an asset and also promises or has the option (either in the same contract or in another contract) to repurchase the asset. The repurchased asset may be the asset that was originally sold to the customer, an asset that is substantially the same as that asset, or another asset of which the asset that was originally sold is a component.

A 606-10-55-68: If an entity has an obligation or a right to repurchase the asset (a forward or a call option), a customer does not obtain control of the asset because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset even though the customer may have physical possession of the asset. Consequently, the entity should account for the contract as either of the following:

a.  A lease in accordance with Topic 840 on leases, if the entity can or must repurchase the asset for an amount that is less than the original selling price of the asset unless the contract is part of a sale-leaseback transaction. If the contract is part of a sale-leaseback transaction, the entity should account for the contract as a financing arrangement and not as a sale-leaseback in accordance with Subtopic 840-40.

b.  A financing arrangement in accordance with paragraph 606-10-55-70, if the entity can or must repurchase the asset for an amount that is equal to or more than the original selling price of the asset.

1-19: Accounting for priority review vouchers (updated May 2023)

Background

Under the priority review voucher program, developers are “rewarded” for developing treatments for certain neglected or rare pediatric diseases. Following, and contingent upon, the treatment’s approval by the Food and Drug Administration (FDA), the developer receives a voucher for priority review (priority review voucher or PRV) for a future drug candidate. A PRV provides the developer an expedited review by the FDA for a future drug candidate. A PRV can be transferred to an unrelated third party, to which it would afford the same benefits.

During 20X1, Company B received a PRV from the FDA concurrent with the successful internal development of a drug that treats a rare disease. On January 1, 20X3, Company A acquires the PRV from Company B for $110 million.

Question: How should (1) Company B account for initial receipt of the PRV from the FDA, (2) Company B account for the subsequent sale of the PRV to Company A, and (3) Company A account for the subsequent purchase of the PRV from Company B?

Solution

(1) Company B’s accounting for the initial receipt of the PRV from the FDA

When Company B receives the PRV from the FDA, it does not make any payments or incur any incremental costs related to the asset. Accordingly, Company B would measure and record the PRV asset at zero value on the date it is received.

(2) Company B’s accounting for subsequent sale of the PRV to Company A

When the PRV is sold to Company A, Company B will recognize a gain on sale. The sale of the PRV asset generally should not be presented as revenue by Company B because the selling of PRVs would not represent a vendor / customer relationship and PRVs are not likely outputs of Company B’s ordinary activities. Other than for the sale of long-lived assets, there is no explicit guidance under US GAAP on the income statement presentation of gains from the sale of nonfinancial assets. As such, Company B should consider the nature of the gain in the context of its business model and financial reporting model in assessing whether it is more appropriate to present the gain as a component of operating profit (if an operating profit subtotal is presented) or as a non-operating item.

(3) Company A’s accounting for the subsequent purchase of the PRV from Company B

On January 1, 20X9, Company A should recognize the PRV asset at its cost of $110 million. Since the PRV has an alternative future use (specifically Company A can sell the PRV to another third party) and no specified term, it would be deemed to be an indefinite-lived intangible asset. Subsequent to the acquisition, Company A would test the PRV asset for impairment annually, or more frequently if events or changes in circumstances indicate that the indefinite-lived asset might be impaired.

When Company A commits to using the PRV to accelerate the FDA’s review of its own drug candidate, the carrying amount of the PRV should be expensed as research and development. At that point, the PRV no longer has an alternative future use (i.e., the PRV is no longer available to be sold to another party and the drug for which it is used is not yet approved).

Alternatively, if Company A resells the PRV to another third party, the accounting would be the same as when Company B sold the asset. The carrying amount of the PRV asset would be derecognized and any difference between the carrying amount and the proceeds received would be recognized as a gain or loss in the income statement.

Relevant guidance

ASC 730-20-25-13: Non-refundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities pursuant to an executory contractual arrangement shall be deferred and capitalized.

ASC 730-10-25-2(c): Intangible assets purchased from others. The costs of intangible assets that are purchased from others for use in research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be accounted for in accordance with Topic 350, [Intangibles – Goodwill and Other]. The amortization of those intangible assets used in research and development activities is a research and development cost. However, the costs of intangibles that are purchased from others for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred.

ASC 350-30-20: Intangible Assets - Assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.)

ASC 350-30-35-1: The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life shall be amortized; an intangible asset with an indefinite useful life shall not be amortized.

ASC 350-30-35-18: An intangible asset that is not subject to amortization shall be tested for impairment annually and more frequently if events or changes in circumstances indicate that it is more likely than not that the asset is impaired.

610-20-15-2: Except as described in paragraph 610-20-15-4, the guidance in this Subtopic applies to gains or losses recognized upon the derecognition of nonfinancial assets and in substance nonfinancial assets. Nonfinancial assets within the scope of this Subtopic include intangible assets, land, buildings, or materials and supplies and may have a zero carrying value. In substance nonfinancial assets are described in paragraphs 610-20-15-5 through 15-8.

610-20-32-2: When an entity meets the criteria to derecognize a distinct nonfinancial asset or a distinct in substance nonfinancial asset, it shall recognize a gain or loss for the difference between the amount of consideration measured and allocated to that distinct asset in accordance with paragraphs 610-20-32-3 through 32-6 and the carrying amount of the distinct asset. The amount of consideration promised in a contract that is included in the calculation of a gain or loss includes both the transaction price and the carrying amount of liabilities assumed or relieved by a counterparty.

ASC 606-10-20 definition of revenue: Inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations.

ASC 606-10-20 definition of a customer: A party that has contracted with an entity to obtain goods or services that are an output of the entity's ordinary activities in exchange for consideration.