US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 6

6-1 Scope considerations when accounting for collaboration agreements

Background

Company A grants an IP license to a drug compound to Company B and will perform manufacturing services on the compound. Company A receives an upfront payment of $40 million, per-unit payments for manufacturing services performed, and a milestone payment of $150 million upon regulatory approval. Consideration payable under this arrangement is at market rates and all payments received by Company A are non-refundable.

Question: Is this arrangement within the scope of ASC 606?

Solution

Determining whether an arrangement is within the scope of ASC 606 can be a difficult judgment at times. In this case, the arrangement appears to be in the scope of the revenue standard as Company A and Company B appear to have a vendor-customer relationship. Company A is providing a license and manufacturing services to Company B and those goods and services are the outputs of Company A’s ordinary activities. The fees paid are at market rates and payments received are non-refundable. Also, the two companies do not appear to share in the risks and rewards that result from the activities under the arrangement.

Relevant guidance

ASC 606-10-15-3: An entity shall apply the guidance in this Topic to a contract…only if the counterparty to the contract is a customer. A customer is 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...

ASC 808-10-20: Collaborative arrangement: A contractual arrangement that involves a joint operating activity (see paragraph 808-10-15-7). These arrangements involve two (or more) parties that meet both of the following requirements:

a.  They are active participants in the activity (see paragraphs 808-10-15-8 through 15-9).

b.  They are exposed to significant risks and rewards dependent on the commercial success of the activity (see paragraphs 808-10-15-10 through 15-13).

6-3 Contract term

Background

Biotech enters into a ten-year term license arrangement with Pharma under which Biotech transfers to Pharma the exclusive rights to sell product using its intellectual property (IP) in a particular territory. The IP is considered “functional” (as defined) and there are no other performance obligations in the arrangement. Pharma makes an upfront non-refundable payment of $25 million and is obligated to pay an additional $1 million at the end of each year throughout the stated term.

Pharma can cancel the contract for convenience at any time, but must return its rights to the licensed IP to Biotech upon cancellation. Pharma does not receive any refund of amounts previously paid upon cancellation.

Question: What is the contract term for purposes of applying the revenue standard?

Solution

Biotech would likely conclude that the contract term is ten years because Pharma cannot cancel the contract without incurring a substantive termination penalty. The substantive termination penalty in this arrangement is Pharma’s obligation to transfer an asset to Biotech through the return of its exclusive rights to the licensed IP without a refund of amounts paid. Also, since the additional annual payments are due over a ten year period, Biotech would likely conclude that the arrangement contains a significant financing component. Therefore, Biotech would record $25 million plus the present value of the 10 $1 million payments due at the end of each year through the stated term upon transferring control of the license.

Entities should consider termination clauses when assessing contract duration. If a contract can be terminated early for no compensation, enforceable rights and obligations would likely not exist for the entire stated term. The contract may, in substance, be a shorter-term contract with a right to renew. In contrast, a contract that can be terminated early, but requires payment of a substantive termination penalty, is likely to have a contract term equal to the stated term. This is because enforceable rights and obligations exist throughout the stated contract period.

The assessment of whether a substantive termination penalty is incurred upon cancellation could require significant judgment for arrangements that include a license of IP. Factors to consider include the nature of the license, the payment terms (for example, how much of the consideration is paid upfront), the business purpose of contract terms that include termination rights, and the impact of contract cancellation on other performance obligations, if any, in the contract. If management concludes that a termination right creates a contract term shorter than the stated term, management should assess whether the arrangement contains a renewal option that provides the customer with a material right.

Relevant guidance

ASC 606-10-25-3: Some contracts with customers may have no fixed duration and can be terminated or modified by either party at any time. Other contracts may automatically renew on a periodic basis that is specified in the contract. An entity shall apply the guidance in this Topic to the duration of the contract (that is, the contractual period) in which the parties to the contract have present enforceable rights and obligations…

ASC 606 Basis of Conclusion 50: The Boards decided that Topic 606 should not apply to wholly unperformed contracts if each party to the contract has the unilateral enforceable right to terminate the contract without penalty. Those contracts would not affect an entity’s financial position or performance until either party performs. In contrast, there could be an effect on an entity’s financial position and performance if only one party could terminate a wholly unperformed contract without penalty. For instance, if only the customer could terminate the wholly unperformed contract without penalty, the entity is obliged to stand ready to perform at the discretion of the customer. Similarly, if only the entity could terminate the wholly unperformed contract without penalty, it has an enforceable right to payment from the customer if it chooses to perform.

6-5 Assessing distinct promises (license and R&D services)

Background

Company A, a biotechnology company, enters into an arrangement to provide Company B with a license to manufacture and commercialize an early-stage drug compound as well as perform ongoing R&D services on Company B’s behalf to continue to develop the compound. The compound is currently in Phase II clinical trials. The license is delivered to Company B in the first quarter and the R&D services will be provided over time.

Question: What factors should Company A consider when assessing whether the license is a separate performance obligation in this arrangement?

Solution

Significant judgment is required when identifying the number of performance obligations in an arrangement that includes a license to IP as well as R&D services performed by the licensor. In determining whether the license is distinct, Company A should consider whether the license is capable of being distinct and whether the promise to transfer the license is distinct in the context of the contract.

Capable of being distinct

This criterion is met if Company B can benefit from the license on its own or with other readily available resources. The license may not be capable of being distinct if the R&D services are so specialized that the services could only be performed by Company A as opposed to Company B or another qualified third party.

Distinct in the context of the contract

This criterion is met if the promise to transfer the license is separately identifiable from the R&D services. The license may be separately identifiable from the R&D services if the R&D services are not expected to significantly modify or customize the initial IP. This is often the case with clinical trials when the purpose is to validate the usage and efficacy of a drug versus significantly modifying or customizing the initial IP (e.g., the drug compound).

Conversely, in the case of very early stage IP (e.g., within the drug discovery cycle) whereby the R&D services are expected to involve significant further development of the drug formula or biological compound, Company A might conclude that the license is not separately identifiable from the R&D services.

Company A should also evaluate if the R&D services are optional; that is, could the customer decide to cancel at any time with no penalty or hire another vendor or biotech to perform the services. Optional services may indicate that the only enforceable rights and obligations relate to the license of IP. In that circumstance, Company A would need to assess if a material right exists with regard to future optional R&D services, which may be the case, for example, if the R&D services were priced at an amount below standalone selling price.

Relevant guidance

ASC 606-10-25-19: A good or service that is promised to a customer is distinct if both of the following criteria are met:

• The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).

• The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).

ASC 606-10-25-20: A customer can benefit from a good or service... if it can be used, consumed, sold for an amount that is greater than scrap value, or otherwise held in a way that generates economic benefits. For some goods or services, a customer may be able to benefit from a good or service on its own. For other goods or services, a customer may be able to benefit from the good or service only in conjunction with other readily available resources. A readily available resource is a good or service that is sold separately (by the entity or another entity) or a resource that the customer has already obtained from the entity (including goods or services that the entity will have already transferred to the customer under the contract) or from other transactions or events. Various factors may provide evidence that the customer can benefit from a good or service either on its own or in conjunction with other readily available resources. For example, the fact that the entity regularly sells a good or service separately would indicate that a customer can benefit from the good or service on its own or with other readily available resources.

ASC 606-10-55-56: ...Examples of licenses that are not distinct from other goods or services promised in the contract include the following:

a. A license that forms a component of a tangible good and that is integral to the functionality of the good

b. A license that the customer can benefit from only in conjunction with a related service...

6-7 Significant financing component

Background

On January 1, 20X9, Company A entered into a six-year arrangement to transfer a license of functional intellectual property (IP) in exchange for a nonrefundable upfront fee of $500 million and an additional $200 million ($40 million per year) payable in five equal, annual installments from 2020 through 2024. As such, Company A transferred control of the license to Company B at that time. There are no other performance obligations in the contract and Company A has concluded (1) collection of the consideration is probable and (2) there is a substantive termination penalty in the event the customer cancels the contract.

Question: Does a significant financing component exist?

Solution

A significant financing component exists at the inception of the arrangement because Company A provides Company B with a significant financing benefit in that Company A transferred control of the license at the inception of the arrangement but Company B is effectively paying in arrears over a five year period. As such, Company A would present value the five annual installments of $40 million at the Company B’s borrowing rate, which at an assumed rate for this example of 5%, would equal $173 million. Company A would recognize the $173 million as revenue on January 1, 20X9, when Company A transferred control of the license to functional IP to Company B. Company A would also recognize $27 million of interest income over the remainder of the contract term.

Relevant guidance

ASC 606-10-32-15: In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. In those circumstances, the contract contains a significant financing component. A significant financing component may exist regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract.

ASC 606-10-32-19: To meet the objective in paragraph 606-10-32-16 when adjusting the promised amount of consideration for a significant financing component, an entity shall use the discount rate that would be reflected in a separate financing transaction between the entity and its customer at contract inception. That rate would reflect the credit characteristics of the party receiving financing in the contract, as well as any collateral or security provided by the customer or the entity, including assets transferred in the contract. An entity may be able to determine that rate by identifying the rate that discounts the nominal amount of the promised consideration to the price that the customer would pay in cash for the goods or services when (or as) they transfer to the customer. After contract inception, an entity shall not update the discount rate for changes in interest rates or other circumstances (such as a change in the assessment of the customer’s credit risk).

6-9 Accounting for options to additional IP

Background

Company A enters into an arrangement to provide Company B with a license to use its IP for a single indication. Company A also provides Company B with an option during the term of the arrangement to add additional indications if the IP is proven effective for those other indications.

Question: How should Company A evaluate the option it provided to Company B?

Solution

Company A should consider whether the option provided to Company B offers a future discount that is incremental to the range of discounts typically given to the same class of customer.

If the option provides a material right to Company B, there are two performance obligations in the arrangement: the license to use Company A’s IP for a single indication and the right to licenses for additional indications in the future. In this scenario, Company A would need to allocate a portion of the transaction price to both the current license and the right to future licenses based on the standalone selling price of each performance obligation. If the standalone selling price for Company B’s option is not directly observable, Company A should estimate it. That estimate should reflect the discount that Company B would obtain when exercising the option, adjusted for (1) any discount that would otherwise be available and (2) the likelihood that the option will be exercised. The amount allocated to the material right would be recognized when the future licenses transfer to Company B or when the option expires.

If the option to obtain additional licenses are at a price that reflects the standalone selling price for the additional license, the option does not provide Company B with a material right even if the option can only be exercised because of the previous contract. In this scenario, Company A should not assign any portion of the transaction price of the initial contract to the option and instead account for the exercise of the right if and when Company B choses to purchase the additional licenses.

Relevant guidance

ASC 606-10-55-42: If, in a contract, an entity grants a customer the option to acquire additional goods or services, that option gives rise to a performance obligation in the contract only if the option provides a material right to the customer that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market). If the option provides a material right to the customer, the customer in effect pays the entity in advance for future goods or services, and the entity recognizes revenue when those future goods or services are transferred or when the option expires.

ASC 606-10-55-45: If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, then an entity may, as a practical alternative to estimating the standalone selling price of the option, allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration...

6-11 Estimating variable consideration when there are contingent bonus payments

Background

Company A, a contract research organization, enters into an arrangement with Company B, a pharmaceutical company, to perform a clinical trial on a Phase III drug candidate. Company A will receive fixed consideration of $20 million plus an additional milestone or bonus payment of $2 million if it screens 100 patients to enroll in the clinical trial in the first two months of the contract term. Company A has extensive experience enrolling patients and completing similar types of trials in the same field Company B’s drug candidate is targeting. Company A believes (1) there is a large population of patients to potentially screen for the clinical trial and (2) its past experience of screening patients has significant predictive value.

Question: At the inception of the arrangement, should Company A include the bonus payment in the transaction price?

Solution

Since there is a binary outcome as it relates to the bonus (that is, Company A either will or will not screen 100 patients in the first two months), it would generally be expected to use the most likely amount method to estimate variable consideration.

In this case, Company has extensive experience that it believes has predictive value. In addition, screening patients is largely in its control and the contingency is expected to be resolved in a relatively short period of time. Therefore, Company A would likely include the $2 million bonus as variable consideration in the transaction price at inception. It would then consider the variable consideration constraint and is likely to conclude that it is probable there will not be a significant reversal of cumulative revenue due to the large upfront payment ($20 million) coupled with the expected stage of completion at the two-month mark when the contingency is expected to be resolved.

Assuming the performance obligation is satisfied over time, the entire $22 million would be subject to recognition from inception. Said differently, no revenue needs to be “held back” due to the constraint.

Relevant guidance

ASC 606-10-32-2: An entity shall consider the terms of the contract and its customary business practices to determine the transaction price. The transaction price is the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer... The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or both.

ASC 606-10-32-8: An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:

a.  The expected value—The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.

b.  The most likely amount—The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not).

ASC 606-10-32-12: ...Factors that could increase the likelihood or the magnitude of a revenue reversal include, but are not limited to, any of the following:

1.  The amount of consideration is highly susceptible to factors outside the entity’s influence. Those factors may include volatility in a market, the judgment or actions of third parties, weather conditions, and a high risk of obsolescence of the promised good or service.

2.  The uncertainty about the amount of consideration is not expected to be resolved for a long period of time.

3.  The entity’s experience (or other evidence) with similar types of contracts is limited, or that experience (or other evidence) has limited predictive value.

4.  The entity has a practice of either offering a broad range of price concessions or changing the payment terms and conditions of similar contracts in similar circumstances.

5.  The contract has a large number and broad range of possible consideration amounts.

6-12A Accounting for a change in estimate of total expected costs when using a cost-to-cost measure of progress (added May 2023)

Background

In 20X1, Company A entered into a license arrangement with Company B to develop a potential drug currently in a Phase I clinical trial. As part of the arrangement, Company A agreed to provide Company B a perpetual license to Company A’s proprietary intellectual property (IP) related to the drug candidate. Company A will provide research and development (R&D) services to Company B through the completion of the phase 1 clinical trials. Company A receives an upfront payment of $50 million at the inception of the arrangement and is eligible to receive a milestone payment of $10 million upon regulatory approval.

Company A determined the license to the proprietary IP and R&D services are not distinct, and thus are accounted for as a single performance obligation that is satisfied over time. This example does not address how the company identified the performance obligations for this arrangement. For information on how to assess distinct promises, see FAQ 6-5.

Company A included the $50 million upfront payment in the transaction price at inception. In estimating variable consideration related to the regulatory milestone, at inception Company A concluded that the most likely amount was zero. Company A determined that it would be appropriate to use a cost-to-cost method to measure progress because this measure of progress best depicts its transfer of control of the R&D services to Company B under the contract.

At contract inception, Company A’s best estimate of total costs to complete the Phase 1 clinical trials was $25 million. Through 20X2, Company A incurred $15 million of actual costs and recognized $30 million of cumulative revenue (($15 million incurred costs to date divided by $25 million estimated total costs) times $50 million transaction price). At December 31, 20X3, Company A’s best estimate of the costs to complete the Phase 1 clinical trials increased to $45 million. This was due to updates in the trial design from a November 20X3 notification from the FDA stating that an additional patient cohort had to be added to the trial based on its review. Cumulative actual costs of $30 million had been incurred through December 31, 20X3.

Question: How should Company A account for the change in estimated costs in its December 31, 2023 annual financial statements?

Solution

Company A considers the increase in total estimated costs necessary to satisfy the R&D services performance obligation a change in estimate. Company A assessed the facts and circumstances surrounding the change in estimate, which resulted from new information communicated by the FDA in November 20X3. As a result, when completing its periodic update to estimated costs to complete and, in turn, cumulative progress toward completion of the performance obligation, Company A would use the updated estimate of total costs of $45 million as the denominator in the cost-to-cost model and recalculate the cumulative amount of revenue that should be recognized. That cumulative amount of revenue is compared to the cumulative amount of revenue recognized as of the prior period end (December 31, 20X2). This results in cumulative revenue of $33.3 million (($30 million incurred costs divided by $45 million estimated total costs) times $50 million transaction price). Company A would need to recognize $3.3 million of revenue for the year ended December 31, 20X3 as it has already recognized $30 million in cumulative revenue through December 31, 20X2.

It should be noted that depending on how the numerator and the denominator change as a result of new cost estimates, there may be circumstances when a company would recognize negative revenue for the period. For example, if the facts were changed such that cumulative actual costs incurred through December 31, 20X3 were $26 million, Company A would have recognized negative revenue of $1.1 million because cumulative revenue should be $28.9 million (($26 million incurred costs / $45 million estimated total costs) times $50 million transaction price) compared to the $30 million in cumulative revenue recognized as of the prior period end.

Relevant guidance

606-10-25-31: For each performance obligation satisfied over time in accordance with paragraphs 606-10-25-27 through 25-29 , an entity shall recognize revenue over time by measuring the progress toward complete satisfaction of that performance obligation. The objective when measuring progress is to depict an entity's performance in transferring control of goods or services promised to a customer (that is, the satisfaction of an entity's performance obligation).

ASC 606-10-25-32: An entity shall apply a single method of measuring progress for each performance obligation satisfied over time, and the entity shall apply that method consistently to similar performance obligations and in similar circumstances. At the end of each reporting period, an entity shall remeasure its progress toward complete satisfaction of a performance obligation satisfied over time.

606-10-25-33: Appropriate methods of measuring progress include output methods and input methods. Paragraphs 606-10-55-16 through 55-21 provide guidance for using output methods and input methods to measure an entity's progress toward complete satisfaction of a performance obligation. In determining the appropriate method for measuring progress, an entity shall consider the nature of the good or service that the entity promised to transfer to the customer.

ASC 606-10-25-35: As circumstances change over time, an entity shall update its measure of progress to reflect any changes in the outcome of the performance obligation. Such changes to an entity’s measure of progress shall be accounted for as a change in accounting estimate in accordance with Subtopic 250-10 on accounting changes and error corrections.

ASC 606-10-32-8: An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:

a.  The expected value—The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts. An expected value may be an appropriate estimate of the amount of variable consideration if an entity has a large number of contracts with similar characteristics.

b.  The most likely amount—The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract). The most likely amount may be an appropriate estimate of the amount of variable consideration if the contract has only two possible outcomes (for example, an entity either achieves a performance bonus or does not).

ASC 606-10-55-20: Input methods recognize revenue on the basis of the entity’s efforts or inputs to the satisfaction of a performance obligation (for example, resources consumed, labor hours expended, costs incurred, time elapsed, or machine hours used) relative to the total expected inputs to the satisfaction of that performance obligation.

ASC 250-10-45-17:A change in accounting estimate shall be accounted for in the period of change if the change affects that period only or in the period of change and future periods if the change affects both. A change in accounting estimate shall not be accounted for by restating or retrospectively adjusting amounts reported in financial statements of prior periods or by reporting pro forma amounts for prior periods.

6-13A Determine who the customer is when a Manufacturer sells product to a Wholesaler

Background

Company A, a pharmaceutical company, enters into an arrangement with Wholesaler X, whereby Wholesaler X can purchase drug tablets for list price (often referred to as Average Wholesale Price or AWP), less 3%. Wholesaler X can only return drug tablets to Pharma six months prior to expiry. Wholesaler X enters into a contract with Hospital Y to sell the drug for list price plus 2%. Hospital Y does not need to buy from Wholesaler X; it can negotiate pricing for drug tablets with multiple wholesalers to obtain the cheapest price. Wholesaler X has the ability to sell the drug tablet to any customer at any price and can decide whether to sell the drug to Hospital Y or another entity (e.g., another hospital or pharmacy). Company A’s sales team is actively marketing the drug to Wholesaler X’s customers, including Hospital Y.

On January 1, 20X2, Wholesaler X orders 100,000 tablets (expiry is June 30, 20X6) from Company A. Company A delivers the units to Wholesaler X’s warehouse. On February 20, 20X2, Hospital Y orders 25,000 tablets from Wholesaler X. Wholesaler X delivers the drugs to Hospital Y. Company A is responsible for the acceptability of the drug such that Hospital Y directs any quality issues to Company A.

Question: Who is Company A’s customer and how should Company A account for this transaction?

Solution

Company A would assess the transactions (sale of drug) between Company A and Wholesaler X to determine whether Wholesaler X is a principal or an agent. If Company A transfers control of the drug tablets to Wholesaler X, Wholesaler X is a principal, in which case revenue is recognized upon transfer. Otherwise, Wholesaler X is acting as Company A’s agent, in which case Company A would recognize revenue upon control of the drug tablets transferring to Hospital Y. 

Company A would consider the indicators of whether Wholesaler X controls the goods (drug tablets) before they are transferred to Hospital Y. Hospital Y can negotiate the price with Wholesaler X and Hospital Y can choose to contract with a different wholesaler to obtain the cheapest price. Wholesaler X has the ability to sell the drug tablet to any customer and can decide whether to sell the drug to Hospital Y or another entity (e.g., another hospital or pharmacy). Wholesaler X has inventory risk because Wholesaler X obtained control of drug tablets before obtaining a contract with Hospital Y and has the ability to direct the use of and obtain substantially all of the benefits of transferring the drug tablets to its customers. 

There are also indicators present that could point to Wholesaler X being Company A’s agent. Company A is responsible for the acceptability of the drugs and Wholesaler X has the right to return the product in four years. This does not, however, mitigate Wholesaler X’s inventory risk. 

In this example, the indicators appear to support a conclusion that Wholesaler X is the principal in the sale of the drugs to Hospital Y. Therefore, Wholesaler X is Company A’s customer for the order of 100,000 tablets. 

Because Wholesaler X is Company A’s customer, Company A should record revenue, net of variable consideration for any estimated discounts, rebates, or contractual allowances that will become due and payable once the drug is sold on to Wholesaler X’s customers, when control of the 100,000 tablets transfers to Wholesaler X. 

The determination often requires judgment and impacts both the timing and amount of revenue ultimately recognized. Companies should carefully assess the facts and circumstances when making the principal vs. agent assessment.

Relevant guidance

ASC 606-10-55-36: When another party is involved in providing goods or services to a customer, the entity should determine whether the nature of its promise is a performance obligation to provide the specified goods or services itself (that is, the entity is a principal) or to arrange for those goods or services to be provided by the other party (that is, the entity is an agent). An entity determines whether it is a principal or an agent for each specified good or service promised to the customer. A specified good or service is a distinct good or service (or a distinct bundle of goods or services) to be provided to the customer (see paragraphs 606-10-25-19 through 25-22). If a contract with a customer includes more than one specified good or service, an entity could be a principal for some specified goods or services and an agent for others.

ASC 606-10-55-36A: To determine the nature of its promise (as described in paragraph 606-10-55-36), the entity should:

a. Identify the specified goods or services to be provided to the customer (which, for example, could be a right to a good or service to be provided by another party [see paragraph 606-10-25-18])

b. Assess whether it controls (as described in paragraph 606-10-25-25) each specified good or service before that good or service is transferred to the customer.

 ASC 606-10-55-37: An entity is a principal if it controls the specified good or service before that good or service is transferred to a customer. However, an entity does not necessarily control a specified good if the entity obtains legal title to that good only momentarily before legal title is transferred to a customer. An entity that is a principal may satisfy its performance obligation to provide the specified good or service itself or it may engage another party (for example, a subcontractor) to satisfy some or all of the performance obligation on its behalf.

ASC 606-10-55-38: An entity is an agent if the entity’s performance obligation is to arrange for the provision of the specified good or service by another party. An entity that is an agent does not control the specified good or service provided by another party before that good or service is transferred to the customer. When (or as) an entity that is an agent satisfies a performance obligation, the entity recognizes revenue in the amount of any fee or commission to which it expects to be entitled in exchange for arranging for the specified goods or services to be provided by the other party. An entity’s fee or commission might be the net amount of consideration that the entity retains after paying the other party the consideration received in exchange for the goods or services to be provided by that party.

ASC 606-10-55-39: Indicators that an entity controls the specified good or service before it is transferred to the customer (and is therefore a principal [see paragraph 606-10-55-37]) include, but are not limited to, the following:

 a. The entity is primarily responsible for fulfilling the promise to provide the specified good or service. This typically includes responsibility for the acceptability of the specified good or service (for example, primary responsibility for the good or service meeting customer specifications). If the entity is primarily responsible for fulfilling the promise to provide the specified good or service, this may indicate that the other party involved in providing the specified good or service is acting on the entity’s behalf.

 b. The entity has inventory risk before the specified good or service has been transferred to a customer or after transfer of control to the customer (for example, if the customer has a right of return). For example, if the entity obtains, or commits to obtain, the specified good or service before obtaining a contract with a customer, that may indicate that the entity has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the good or service before it is transferred to the customer.

c. The entity has discretion in establishing the price for the specified good or service. Establishing the price that the customer pays for the specified good or service may indicate that the entity has the ability to direct the use of that good or service and obtain substantially all of the remaining benefits. However, an agent can have discretion in establishing prices in some cases. For example, an agent may have some flexibility in setting prices in order to generate additional revenue from its service of arranging for goods or services to be provided by other parties to customers.

ASC 606-10-55-39A: The indicators in paragraph 606-10-55-39 may be more or less relevant to the assessment of control depending on the nature of the specified good or service and the terms and conditions of the contract. In addition, different indicators may provide more persuasive evidence in different contracts.

ASC 606-10-32-25: Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer). Consideration payable to a customer also includes credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer). Consideration payable to a customer also includes equity instruments (liability or equity classified) granted in conjunction with selling goods or services (for example, shares, share options, or other equity instruments). An entity shall account for consideration payable to a customer as a reduction of the transaction price and, therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service (as described in paragraphs 606-10-25-18 through 25-22) that the customer transfers to the entity. If the consideration payable to a customer includes a variable amount, an entity shall estimate the transaction price (including assessing whether the estimate of variable consideration is constrained) in accordance with paragraphs 606-10-32-5 through 32-13.

6-15 Sales-based milestones

Background

Company A entered into an arrangement with Company B, whereby Company A has agreed to provide to Company B a license to its IP. The license was transferred to Company B at contract inception. In return, Company B has paid Company A an up-front payment of $10 million and will pay Company A an additional $20 million in the event Company B’s annual sales of products associated with this licensed IP exceed $250 million.

Question: How should Company A account for the contingent sales-based milestone?

Solution

We believe the $20 million sales-based milestone would be viewed as a sales-based royalty given it is based on Company B’s subsequent sales of product. Because this example relates to the license of IP and the milestone is tied to sales, the royalty exception applies.

Under the royalty exception, the milestone is recognized at the later of (1) when the subsequent sales or usage occurs or (2) full or partial satisfaction of the performance obligation to which some or all of the sales-based milestone has been allocated.

Company A would recognize the $20 million sales-based milestone as revenue when the subsequent sales mandating payment occur because this is the latter of when the subsequent sales occurs and when the performance obligation was satisfied (control of the license transferred at the beginning of the contract).

Relevant guidance

ASC 606-10-32-5: If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.

ASC 606-10-32-6: An amount of consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items. The promised consideration also can vary if an entity’s entitlement to the consideration is contingent on the occurrence or nonoccurrence of a future event. For example, an amount of consideration would be variable if either a product was sold with a right of return or a fixed amount is promised as a performance bonus on achievement of a specified milestone.

ASC 606-10-55-65: Notwithstanding the guidance in paragraphs 606-10-32-11 through 32-14, an entity should recognize revenue for a sales-based or usage-based royalty promised in exchange for a license of IP only when (or as) the later of the following events occurs:

a.  The subsequent sale or usage occurs.

b.  The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).

ASC 606-10-55-65A: The guidance for a sales-based or usage-based royalty in paragraph 606-10-55-65 applies when the royalty relates only to a license of intellectual property or when a license of intellectual property is the predominant item to which the royalty relates (for example, the license of intellectual property may be the predominant item to which the royalty relates when the entity has a reasonable expectation that the customer would ascribe significantly more value to the license than to the other goods or services to which the royalty relates).

6-17 Revenue recognition for customers with a history of long delays in payment

Background

Company A, a pharmaceutical company, sells prescription drugs to a governmental entity in Country X. Company A has historically experienced long delays in payment for sales to this entity due to slow economic growth and high debt levels in Country X. Company A currently has outstanding receivables from sales to this entity over the last three years and continues to sell product at its normal market price. The receivables are non-interest bearing.

Question: How should Company A account for the outstanding receivables and future sales to Country X?

Solution

At the inception of each arrangement, Company A will need to evaluate its contract with the governmental entity to determine if it is probable that it will collect the amounts to which it is entitled in exchange for the prescription drugs. ASC 606 indicates that for purposes of determining the transaction price, the entity should consider the variable consideration guidance, including the possibility of price concessions. If, based on its historical experience, Company A expects to ultimately provide a price concession to collect its receivable, then the transaction price would be reduced by the amount of the expected price concession. Company A would then evaluate whether it is probable it will collect the adjusted transaction price. Assuming the collectibility hurdle is met, the transaction price will be recognized as Company A satisfies its performance obligation of delivering the drugs.

Additionally, if by agreement or based on past experience with the governmental entity, the amount of time expected between the sale of the prescription drug and expected payment from the governmental entity exceeds one year, before concluding on the final amount of the transaction price, Company A will need to consider if there is a significant financing element in the arrangement.

Company A will need to continually evaluate its outstanding receivables for impairment relating to the customer’s credit risk. Company A needs to consider whether any subsequent billing adjustments are concessions granted to the customer (i.e., a modification to the transaction price) or a credit adjustment (i.e., a write-off of an uncollectible amount from the governmental entity). A modification of the transaction price reduces the amount of revenue recognized, while a credit adjustment is an impairment assessed under ASC 310, Receivables, and recognized as a bad debt expense. The facts and circumstances specific to the adjustment should be considered, including the entity’s past business practices and ongoing relationship with the customer, to make this determination.

Relevant guidance

ASC 606-10-25-1: An entity shall account for a contract with a customer that is within the scope of this Topic only when all of the following criteria are met… (e) It is probable that the entity will collect substantially all of the consideration to which it will be entitled in exchange for the goods or services that will be transferred to the customer... In evaluating whether collectability of an amount of consideration is probable, an entity shall consider only the customer’s ability and intention to pay that amount of consideration when it is due. The amount of consideration to which the entity will be entitled may be less than the price stated in the contract if the consideration is variable because the entity may offer the customer a price concession...

ASC 606-10-32-11: An entity shall include in the transaction price some or all of an amount of variable consideration…only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

ASC 606-10-32-15: In determining the transaction price, an entity shall adjust the promised amount of consideration for the effects of the time value of money if the timing of payments agreed to by the parties to the contract (either explicitly or implicitly) provides the customer or the entity with a significant benefit of financing the transfer of goods or services to the customer. In those circumstances, the contract contains a significant financing component. A significant financing component may exist regardless of whether the promise of financing is explicitly stated in the contract or implied by the payment terms agreed to by the parties to the contract.

ASC 606-10-32-18: As a practical expedient, an entity need not adjust the promised amount of consideration for the effects of a significant financing component if the entity expects, at contract inception, that the period between when the entity transfers a promised good or service to the customer and when the customer pays for that good or service will be one year or less.

ASC 606 Example 1 – Collectibility of the consideration

6-19 Right of return

Background

Company A sells cardiac drugs through a number of wholesale and retail customers. The drugs have a shelf life of 24 months from the date manufactured. Both wholesalers and retailers can return the drugs from six months before to six months after the expiration date, subject to compliance with other provisions in Company A’s returns policy.

Company A has sold these drugs for the past two years. Through December 31, 20X9, 3% of the drugs have been returned in accordance with policy.

On December 31, 20X9, Company A delivered 100 units to Distributor Z for $200 each, for a total sale of $20,000.

Question: How much revenue can Company A recognize on December 31, 20X9?

Solution

Company A would not be able to recognize the full $20,000 as revenue at December 31, 20X9.

Instead, Company A will need to utilize judgment to determine the exact amount of revenue to recognize on December 31, 20X9. Company A will first need to determine the level of sales for which it is probable there will be no significant revenue reversal due to product returns. Company A will need to analyze its return volume, return patterns, current demand levels, the level of inventory currently in the distribution channel, and any new or upcoming Company A or competitor products that may render the product obsolete or otherwise impact product demand.

Although Company A has sold the product for 2 years and has a history of returns experience, because of the extended nature of the return policy, it should assess whether the returns experience is sufficient to develop its returns estimate. However, even in a circumstance where a company has a limited history to draw upon to determine its estimate of returns, it would nonetheless need to determine if there is a minimum level of sales for which it is probable that a change in estimate would not cause a significant reversal of revenue, and record revenue for those sales.

To the extent Company A is able to determine that it is probable there will not be a significant reversal of cumulative revenue recognized in the future, it should reduce the revenue recognized as of December 31, 20X9 by the amount of the estimated returns. For example, if Company A estimates a 3% return rate (using the expected value approach for measuring variable consideration), it would recognize net revenue of $19,400 ($20,000 total order - (3% x $20,000 product sales)) at December 31, 20X9, a refund liability of $600 (3% x $20,000 product sales), and an asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability. The asset would be measured at the carrying amount of goods at the time of the sale, net of any impairment for expected costs to recover the products or decreases in the value of returned products (e.g., due to the limited remaining shelf life of returned products).

Relevant guidance

ASC 606–10–55-22: In some contracts, an entity transfers control of a product to a customer and also grants the customer the right to return the product for various reasons (such as dissatisfaction with the product) and receive any combination of the following:

• A full or partial refund of any consideration paid

• A credit that can be applied against amounts owed, or that will be owed, to the entity

• Another product in exchange.

ASC 606-10-55-23: To account for the transfer of products with the right of return..., an entity should recognize all of the following:

• Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for products expected to be returned)

• A refund liability

• An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.

ASC 606-10-55-25: An entity should apply the guidance in paragraphs 606-10-32-2 through 32-27 (including the guidance on constraining estimates of variable consideration in paragraphs 606-10-32-11 through 32-13) to determine the amount of consideration to which the entity expects to be entitled (that is, excluding the products expected to be returned)...

6-21 Rebates paid to a customer’s customer

Background

Company A enters into an arrangement with Distributor X for the sale of pharmaceutical drugs. Distributor X then sells the product to Customer B. Customer B is entitled to a sales rebate from Company A of 25% of the sales price of the first 100 units if 1,000 units are purchased.

Company A has developed a relationship with Customer B after selling pharmaceutical drugs for a number of years. Further, Company A has offered a similar sales arrangement to Customer B in prior years.

The unit selling price for each product is $100. Company A believes that it has sufficient basis to estimate that the end customer will purchase exactly 1,000 units during the year and earn the full rebate.

Question: How should Company A account for rebates to be paid to its customer’s customer?

Solution

The performance obligation in the contract is the promise to deliver individual units of the pharmaceutical drugs to Distributor X as requested over the term of the sales arrangement. To determine the transaction price, Company A will need to estimate the effects of the rebates offered to Distributor X’s customer. Since Company A estimates that 1,000 units will be delivered to Customer B, the total rebate will be $2,500 (i.e., 25% rebate x 100 units x $100 price per unit). The estimated rebate serves as a reduction from the contractual sales price.

To determine the amount of rebate to recognize upon each product sale, Company A would take the full estimated rebate ($2,500) and divide it by the sales price of the 1,000 units (Company A’s expected sales). As each of the units are shipped, Company A would recognize a rebate accrual of 2.5% ($2,500 total rebate/$100,000 anticipated sales). The rebate would be accrued as an offset to revenue. Company A would record sales to Distributor X at a transaction price of $97.50 ($100 less 2.5% discount). At the end of each quarter, Company A would revise the estimate of sales and true up the calculation and rebate that will be due at the end of the arrangement. This true up would include a cumulative adjustment on shipments through that date.

Even though the product is sold to Distributor X and the rebates are paid to Customer B, the classification of the payment is treated as a reduction of revenue.

Relevant guidance

ASC 606-10-32-25: Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer). Consideration payable to a customer also includes credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer). An entity shall account for consideration payable to a customer as a reduction of the transaction price and, therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service (as described in paragraphs 606-10-25-18 through 25-22) that the customer transfers to the entity. If the consideration payable to a customer includes a variable amount, an entity shall estimate the transaction price (including assessing whether the estimate of variable consideration is constrained) in accordance with paragraphs 606-10-32-5 through 32-13.

6-23 Accounting for retroactive rebates

Background

Company A has a multi-year contract with Company B to sell pharmaceutical drugs and agrees to pay Company B an annual rebate if Company B completes a specified cumulative level of purchases during any year of the contract period. The amount of rebate varies based on the following tiered structure. Based on its historical experience of rebates due to Company B, Company A has assigned probabilities to each possible outcome.

The unit price for each product is $100. Company A has determined that the “expected value” method better predicts the amount of consideration to which it will be entitled. Company A concludes that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty is resolved.

Question: How should Company A account for the rebate expected to be paid to the customer at the end of the year?

Solution

Under the expected value approach, Company A would estimate the rebate to be 2.45% based on a probability-weighted assessment of each possible scenario (i.e., (0% rebate x 15% likelihood) + (2% rebate x 60% likelihood) + (5% rebate x 25% likelihood)). Therefore, as each unit is shipped during the year, Company A would recognize a rebate accrual of $2.45 and revenue of $97.55 under this approach. At the end of each quarter, Company A would revise the estimate of sales and true up the calculation and rebate that will be due at the end of the arrangement. This true up would include a cumulative adjustment on shipments through that date.

The same guidance would generally apply in cases when the customer is a government health system.

Relevant guidance

ASC 606-10-32-25: Consideration payable to a customer includes cash amounts that an entity pays, or expects to pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer). Consideration payable to a customer also includes credit or other items (for example, a coupon or voucher) that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods or services from the customer). An entity shall account for consideration payable to a customer as a reduction of the transaction price and, therefore, of revenue unless the payment to the customer is in exchange for a distinct good or service (as described in paragraphs 606-10-25-18 through 25-22) that the customer transfers to the entity. If the consideration payable to a customer includes a variable amount, an entity shall estimate the transaction price (including assessing whether the estimate of variable consideration is constrained) in accordance with paragraphs 606-10-32-5 through 32-13.

ASC 606-10-32-8: An entity shall estimate an amount of variable consideration by using either of the following methods, depending on which method the entity expects to better predict the amount of consideration to which it will be entitled:

a.  The expected value -The expected value is the sum of probability-weighted amounts in a range of possible consideration amounts...

b.  The most likely amount - The most likely amount is the single most likely amount in a range of possible consideration amounts (that is, the single most likely outcome of the contract)...

6-25 Medicare Part D coverage gap

Background

Pharma currently has one marketed product that is impacted by the Medicare coverage gap provision. Gross revenue of $500 million is earned every quarter. Pharma’s full year estimate of coverage gap subsidies (i.e., reimbursements to the Federal government) is $400 million. Pharma’s inventory does not sit in the channel at the end of a particular quarter (i.e., product sold in Q2 will be sold through to the end customer in Q2). Pharma’s customers primarily enter and exit the Medicare coverage gap in the third and fourth quarters. Pharma’s quarterly revenues, net of coverage gap subsidies, are included in the table below.

Question: How should Pharma account for its coverage gap obligations throughout the year?

Solution

We believe companies can make a policy election between two acceptable methods – a “spreading” approach or a “point-of-sale” approach (sometimes referred to as a “specific identification” approach).

Under the “spreading” approach, the estimated impact of the rebate expected to be incurred for the annual period is recognized ratably using an estimated, effective rebate rate for all of a company’s projected sales to Medicare patients throughout the year. This method appears to be broadly consistent with the accounting for an option (i.e., a material right) provided to a customer.

Companies following this approach will allocate a portion of the transaction price between current sales and the material right, which represents the discount to be provided on future sales to any Medicare-eligible patient within the coverage gap, and recognize the value of the material right into revenue when the coverage gap subsidies are utilized.

However, some companies may experience higher coverage gap liabilities earlier in the year (e.g., with certain more expensive drugs) with sales reverting back to list price in subsequent periods. In these cases, it would not be appropriate to follow a spreading approach that results in a contract asset on the balance sheet as that would, in effect, be inappropriately pulling revenue forward for optional purchases.

If Pharma accounts for coverage gap subsidies as a material right, it would recognize a contract liability at each quarter end for the cumulative year-to-date difference (see chart below) between the actual sales and the amount that should be recognized based on the average selling price for the year.

The contract liability could be calculated in accordance with the practical alternative described in ASC 606-10-55-45. Under that alternative, a company would include the total number of estimated drugs to be sold during the year in the initial measurement of the transaction price of each drug. In other words, all sales of drugs before, during, and after the incurrence of coverage gap liabilities would be recognized, priced at a level discount to reflect the reduced transaction price for drugs sold during the period in which Pharma is liable to fund a portion of patient costs through this program.

It should be noted; however, that some companies may experience higher coverage gap liabilities earlier in the year (e.g., with certain more expensive drugs) with sales reverting back to list price in subsequent periods. In these cases, it would not be appropriate to follow a spreading approach that results in a contract asset on the balance sheet as that would, in effect, be inappropriately pulling revenue forward for optional purchases.

Under the “point-of-sale” method, the rebate is recognized at the time a company recognizes revenue on sales of drugs into the channel that are expected to be resold to Medicare patients who are in the coverage gap. This method is premised on the fact that the Federal government is technically not the customer in the transaction and that each individual sale to an end customer stands on its own. If Pharma accounts for coverage gap subsidies using this approach, it would recognize the subsidies as a reduction of revenue in the periods they are incurred. Therefore, Pharma would record no reduction in revenue in either Q1 or Q2 and would instead reflect a reduction of revenue of $250 and $150 in Q3 and Q4, respectively.

Whichever method is applied would need to be applied on a consistent basis for similar arrangements.

Relevant guidance

ASC 606-10-55-44:... If the standalone selling price for a customer’s option to acquire additional goods or services is not directly observable, an entity should estimate it. That estimate should reflect the discount that the customer would obtain when exercising the option, adjusted for both of the following:

a. Any discount that the customer could receive without exercising the option

b. The likelihood that the option will be exercised.

ASC 606-10-55-45: If a customer has a material right to acquire future goods or services and those goods or services are similar to the original goods or services in the contract and are provided in accordance with the terms of the original contract, then an entity may, as a practical alternative to estimating the standalone selling price of the option, allocate the transaction price to the optional goods or services by reference to the goods or services expected to be provided and the corresponding expected consideration. Typically, those types of options are for contract renewals.

6-27 Synthetic FOB destination

Background

Company A, a pharmaceutical drug manufacturer, sells pharmaceutical drugs to its customers. Company A’s standard sales contracts contain “free on board” (FOB) shipping point terms, and it is clear that title legally transfers at the time the product is provided to the common carrier to be shipped to the customer. At the same time, Company A has a history of replacing or crediting lost or damaged shipments. When a customer indicates that a product has been lost or damaged, Company A provides the customer with a credit to their account or replaces the damaged product at no cost to the customer.

Upon shipment, Company A issues the invoice to the customer using customary payment terms. Over the last three years, customer claims averaged less than 0.2% of total orders and 0.1% of total revenues. Company A has reimbursed all claims for each of the last three years.

Question: When should Company A recognize revenue from the sale of the products?

Solution

Under ASC 606, companies should carefully consider the indicators in ASC 606-10-25-30 as to when control transfers. There is judgment in determining when control transfers, and specific facts and circumstances to a transaction could impact this determination.

In this case, while there are mixed indicators as to when control transfers to the customer, it would appear that transfer of control occurs at the point of shipment. Company A would need to evaluate whether its past practice of replacing lost or damaged product represents a separate performance obligation or possibly a guarantee, if material.

If it concludes that control of the product transfers at the point of shipment, Company A would also need to consider whether there is a separate promise related to providing or arranging for the shipping service. If Company A concluded control transferred at shipping point, Company A could elect an accounting policy to treat shipping and handling as activities to fulfill the promise to transfer the good. Companies applying that election would include any fee received for shipping and handling as part of the transaction price and recognize revenue when control of the good transfers. Costs related to providing the shipping service would be accrued at the time revenue is recognized.

Relevant guidance

ASC 606-10-25-30:...An entity shall consider indicators of the transfer of control, which include, but are not limited to, the following:

• The entity has a present right to payment for
  the asset...

• The customer has legal title to the asset...

• The entity has transferred physical possession of the asset...

• The customer has the significant risks and rewards of ownership of the asset...

• The customer has accepted the asset...

ASC 606-10-25-18B: If shipping and handling activities are performed after a customer obtains control of the good, then the entity may elect to account for shipping and handling as activities to fulfill the promise to transfer the good...

ASC 606-10-25-16A: An entity is not required to assess whether promised goods or services are performance obligations if they are immaterial in the context of the contract with the customer...

6-29 Government vaccine stockpile arrangements

Background

Company A, a pharmaceutical company and public registrant, sells 1 million influenza vaccines to the United States government for placement into a stockpile. In December 20X1, Company A segregates the vaccines in its facility. The influenza vaccines are identified separately as belonging to the United States government. Company A does not have the ability to use the influenza vaccines or to direct them to another customer.

Question: How should Company A account for this arrangement?

Solution

Company A should recognize revenue in December 20X1 when the 1,000 influenza vaccines are placed into US Government stockpile because it qualifies under the August 2017 SEC interpretive guidance, control of the vaccines has transferred to the customer, and the criteria in ASC 606 for recognizing revenue in a bill-and-hold arrangement are satisfied.

Companies that participate in government vaccine stockpile programs that do not meet the scope of the interpretive guidance will need to assess whether control of the product has transferred to the government prior to delivery. ASC 606 does not require a fixed delivery schedule to recognize revenue, but the requirement for transfer of control may not be met if the stockpile inventory is not separately identified as belonging to the customer and is subject to rotation. Even if a company concludes that the bill and hold requirements of ASC 606 are met for certain of these arrangements, to the extent a company is replacing or rotating expired and soon-to-be-expired vaccines for fresh product, ASC 606 requires that replacement or rotation rights be accounted for as a return right, subject to the variable consideration constraint.

In addition, all companies will need to consider their performance obligations under the arrangement. For example, companies need to assess if the storage of stockpile product, the maintenance and rotation of stockpile product, and the shipping of product are separate performance obligations.

Relevant guidance

ASC 606-10-55-81: A bill-and hold arrangement is a contract under which an entity bills a customer for a product but the entity retains physical possession of the product until it is transferred to the customer at a point in time in the future...

ASC 606-10-55-83: In addition to applying the guidance in paragraph 606-10-25-30, for a customer to have obtained control of a product in a bill-and-hold arrangement, all of the following criteria must be met:

a.  The reason for the bill-and-hold arrangement must be substantive (for example, the customer requested the arrangement).

b.  The product must be identified separately as belonging to the customer.

c.  The product currently must be ready for physical transfer to the customer.

d.  The entity cannot have the ability to use the product or to direct it to another customer.

In August 2017, the SEC updated its interpretation on vaccine stockpile programs to conform to the guidance in ASC 606. The updated interpretation states that vaccine manufacturers should recognize revenue and provide the appropriate disclosures when vaccines are placed into US government stockpile programs because control of the vaccines has transferred to the customer (the government) and the criteria in ASC 606 for recognizing revenue in a bill-and-hold arrangement are satisfied. This interpretation is only applicable to childhood disease vaccines, influenza vaccines, and other vaccines and countermeasures sold to the US government for placement in the Strategic National Stockpile.

6-31 Installation obligation – Separate performance obligations

Background

A customer issues a purchase order to Company A, a medical equipment company, for equipment and installation services. Company A will install the equipment at the customer site shortly after delivery and does not expect to have any sales returns. The installation services typically occur consistently over a two month period. Consideration for the equipment and installation services is fixed (i.e., the arrangement does not include any variable consideration or discounts) and the total contract transaction price amounted to $500.

The installation services are relatively routine in nature and Company A is not the only party capable of performing the services. As such, the customer can benefit from the equipment on its own or together with other resources that are readily available (e.g., can engage another party to perform the installation services) and the equipment and installation services are distinct and separately identifiable from one another. Based on this evaluation, Company A concluded the contract included two separate performance obligations to the customer (the equipment and installation services).

Company A has established a standalone selling price of $450 and $150 for the equipment and installation services performance obligations, respectively.

Question: How should Company A recognize revenue for the sale of the equipment and installation services?

Solution

Company A would first allocate the total transaction price of $500 to each performance obligation identified in the contract based on their relative standalone selling price. Based on their standalone selling prices ($450 and $150), this results in 75% ($375) being allocated to the equipment performance obligation and 25% ($125) being allocated to the installation services performance obligation.

The $375 amount allocated to the equipment performance obligation would be recognized as revenue at the point in time at which the customer obtains control of the equipment. The $125 allocated to the installation services performance obligation would be recognized as revenue over the two month period the services are performed by Company A using a measure of progress that depicts Company A’s performance in satisfying the performance obligation.

Relevant guidance

ASC 606-10-25-14: At contract inception, an entity assess the goods or services promised in a contract with a customer and shall identify as a performance obligation each promise to transfer to the customer either: (a) a good or service (or a bundle of goods or services) that is distinct (b) a series of distinct goods or services that are substantially the same and that have the same pattern of transfer to the customer...

ASC 606-10-32-29: To meet the allocation objective, an entity shall allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis in accordance with paragraphs 606-10-32-31 through 32-35, except as specified in paragraphs 606-10-32-36 through 32-38 (for allocating discounts) and paragraphs 606-10-32-39 through 32-41 (for allocating consideration that includes variable amounts).

6-33 Accounting for upgrades and enhancements

Background

Pursuant to a sales agreement, Company A is selling a medical device and is also obligated under the arrangement to deliver specified future upgrades/enhancements to the medical devices sold. The sales terms also require that Company A provide unspecified, “when-and-if-available” upgrades/enhancements of its medical devices during the three-year term of the arrangement. Company A is paid in full under the contract at the inception of the arrangement. Company A expects to deliver the specified upgrades shortly after the initial sale. The arrangement does not contain any general or specific rights of return.

Question: Are obligations to deliver future upgrades or enhancements of a product considered separate performance obligations?

Solution

Both the specified and the unspecified upgrades/enhancements in a contract are promises under ASC 606-10-25 and should be evaluated to determine if they are separate performance obligations that necessitate separate accounting, as defined in ASC 606-10-25-19.

Company A would need to determine if the delivered product is distinct from the specified and unspecified upgrades/enhancements in order to separate the contract into multiple performance obligations. The unspecified upgrades/enhancements in this example would most likely be a separate performance obligation. Company A would also need to determine if the delivered product and specified upgrades are separate performance obligations.

Assuming Company A determined the contract had three separate performance obligations, revenue recognition for the allocated amounts would occur upon transfer of control for the sale of the medical device and specified upgrade. The unspecified upgrades/enhancements would be recognized over the three-year term of the contract.

If one or more of the goods or services significantly modifies or customizes, or are significantly modified or customized by, one or more of the other goods or services promised in the contract, this is an indicator that the good or service is not distinct. For Company A, a critical evaluation would need to be performed to determine if the specified upgrade may significantly modify the medical device and reflects (together with the original device) the combined product that the customer is actually purchasing. On the other hand, if the medical device is fully functional upon delivery and that functionality is not expected to be significantly modified by future upgrades, this would indicate that the medical device is distinct from the promised upgrades.

To the extent that Company A concluded that the delivered medical device is not distinct, the delivered medical device would be bundled with one or more of the other distinct goods or services in the contract and recognized as revenue using an appropriate pattern, based on the guidance in ASC 606-10-25-23. For example, if the initial medical device and the specified upgrades were not considered distinct, revenue would likely be recognized upon the transfer of control of the specified upgrade for the amount allocated to this combined performance obligation, and over the three-year term of the contract for the amount allocated to the unspecified upgrades/enhancements.

Relevant guidance

A contract includes promises to transfer goods or services to a customer. If those goods or services are distinct, the promises are performance obligations and are accounted for separately. A good or service is distinct if the customer can benefit from the good or service on its own or together with other resources that are readily available to the customer and the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract. Paragraphs 606-10-25-14 through 25-22 further discuss identification of performance obligations.

ASC 606-10-25-18: Depending on the contract, promised goods or services may include, but are not limited to, the following:… e. Providing a service of standing ready to provide goods or services (for example, unspecified updates to software that are provided on a when-and-if-available basis) or of making goods or services available for a customer to use as and when the customer decides...

ASC 606-10-25-19: A good or service that is promised to a customer is distinct if both of the following criteria are met:

a. The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct).

b. The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract).

6-35 Accounting for payments to a customer

Background

Company A, a medical device manufacturer, sells products to doctors and hospitals for use in performing certain medical procedures. The Company separately enters into contracts with the doctors to obtain information regarding the use of the products in surgery and postoperative information regarding patient recovery.

Company A concluded it was not possible to obtain this information from someone other than the doctors who perform the procedure and manage the postoperative care.

The doctors collect and maintain the information in a patient registry, which is made available to Company A on an exclusive and controlled basis. Company A pays the doctors a fee in exchange for the registry management service.

Question: How should Company A account for the registry management service payments?

Solution

Because Company A cannot receive registry management service from parties other than the purchasers of its products, it would be unable to conclude that the service it receives is capable of being distinct. As such, Company A should characterize the registry management service payments as a reduction of the transaction price and, therefore, of revenue.

Relevant guidance

ASC 606–10–32–26: If consideration payable to a customer is a payment for a distinct good or service from the customer, then an entity shall account for the purchase of the good or service in the same way that it accounts for other purchases from suppliers. If the amount of consideration payable to the customer exceeds the fair value of the distinct good or service that the entity receives from the customer, then the entity shall account for such an excess as a reduction of the transaction price. If the entity cannot reasonably estimate the fair value of the good or service received from the customer, it shall account for all of the consideration payable to the customer as a reduction of the transaction price.