ASC 606: Challenges for Life Sciences Organizations

Upon initial adoption of Accounting Standards Codification (“ASC” or “Codification”) 606, Revenue from Contracts with Customers (“ASC 606”), organizations within the life sciences industry have faced unique challenges. In this article, we’ll explore two specific challenges faced by life science organizations upon and post-adoption of ASC 606: (1) assessment of collaborative-type arrangements to determine if they are within the scope of ASC 606 and (2) how to identify and account for variable consideration if the contract is within the scope of ASC 606. 

Collaborative-type arrangements 

One of the more common types of organizations within the life sciences sector areis biopharmaceuticals, which primarily research and develop medical treatments from living cells and organisms. Biopharmaceutical organizations commonly perform these activities through collaborative arrangements with other research and development (“R&D”) companies or Big Pharma, for example. 

ASC 606 defines collaborative arrangements as joint operating activities in which all parties are actively involved. The ASC master glossary states that to meet the definition of a collaborative arrangement, there must be active participants involved in the activity, and all participants must be exposed to significant risks and rewards based on the activity’s results. 

With this information in mind, the following is an example of a collaborative arrangement for a biopharmaceutical firm, Company B, to determine whether a contract falls within the scope of ASC 606 or ASC 808, Collaborative Arrangements: 

Example 1: Company A and Company B enter into a collaboration agreement for clinical activities related to developing a vaccine. Company A will supply doses of the vaccine at no charge to Company B. Company B will handle, store, ship, or dispose of materials provided to study sites. Company B will also make sure the study is conducted according to the terms of the agreement and with the approval of a steering committee formed by both organizations.  

The results of the study are jointly owned by Company A and Company B. The two organizations work together to develop the drug, and no compensation or services are provided by one organization to the other. 

Initially, one would expect this type of contract to fall squarely within the guidance of ASC 808. Based on the terms of this agreement, both organizations are active participants: Tthey direct and carry out the activities jointly and have a steering committee composed of representatives from each organization to provide oversight.  

From Company B’s perspective, for example, there is no monetary compensation for the completion of the activities; Company B bears all the costs of the activities being performed and is therefore exposed to the risks and rewards. As both points of the definition are met, this agreement meets the definition of a collaborative agreement and would be within the scope of ASC 808, Collaborative Arrangements. 

Collaborative agreements under ASC 606 

Let’s look at another example. Using our previously established collaborative arrangement, we will add some updated terms.  

Example 2: Instead of both organizations working together to develop a drug, Company B is providing research and development activities for Company A. Company B receives consideration from Company A when it reaches certain milestones within the clinical development process. Company B is responsible for the performance of R&D services, while Company A is responsible for the costs relating to R&D and clinical trials. In addition, a non-refundable upfront payment by Company A was provided to Company B in exchange for Company B granting Company A an exclusive license to its intellectual property to perform clinical studies and, regulatory, and other activities. 

 To determine whether the whole arrangement or a portion of the arrangement falls within the scope of ASC 606, Company B must determine whether the relationship is strictly a collaboration or if there is a customer relationship present. If the relationship is a contract with a customer, it would fall within the guidance of ASC 606.  

Per ASC 606, 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.” In the original example, no party is considered a customer: Tthe parties are working together on the clinical activities, and a contract, as defined under ASC 606, does not exist, as no consideration will be transferred in exchange for materials and activities provided or performed by each of the parties.  

In example 2, however, Company A would be deemed a customer: I; it’s receiving the benefits of the out-licensing and R&D activities performed by Company B, and Company A is providing consideration for the R&D services to Company B. Licensing of its intellectual property and R&D services are considered Company B’s ordinary business activity. As such, this collaboration arrangement would fall within the scope of ASC 606, and Company B would recognize the consideration received from Company A for its licensing and services as revenue. 

Variable consideration under ASC 606 Identifying common forms of variable consideration 

The presentation of revenue related to the sales of pharmaceutical products is an issue unique to pharmaceutical organizations due to the various potential reductions to the amount of transaction consideration to which an organization will be entitled. These potential reductions include discounts, rebates, chargebacks, coupons, and product returns. These post-sale adjustments to transaction prices represent estimates of amounts that a pharmaceutical organization expects it will ultimately owe its customers, creating an accounting challenge.  

Pharmaceutical organizations must assess the accuracy of their estimates each reporting period based on actual reductions to transaction consideration incurred. Standard sales contracts often provide for prompt payment discounts and the right to return a product within a predetermined number of months surrounding the expiration date. Both the prompt payment discounts and the product right of return represent variable consideration, defined within ASC 606-10-32-3 as an element that affects transaction price.  

Under ASC 606, companies must now estimate and recognize the expected amount of variable consideration, such as prompt payment discounts and product returns, at the time the associated revenue is recognized and record such amounts as a reduction to the total amount of revenue recognized. 

Estimation of variable consideration 

ASC 606 provides two methods organizations can use to estimate variable consideration:  

• The expected value method, which uses historical data as the basis to estimate the potential future outcome, and  

• The most likely amount method, which is the single most likely outcome from a range of possible outcomes (this method is more appropriate when there are only two possible outcomes).  

For example, applying an expected product return rate to current sales based on historical actual returns would generally be the more appropriate method to estimate the variable consideration related to product returns. Regardless of the methodology selected, it must be applied consistently, and the estimated value of the variable consideration must be recorded at the time of sale. 

Allocation of variable consideration to multiple performance obligations 

ASC 606 guidance indicates that for contracts which contain multiple performance obligations, it’s possible to allocate variable consideration to only one of the performance obligations to which the variable consideration specifically relates or amongst all performance obligations (in which case it follows the same guidance as the transaction price allocation).  

Using our example from above, if there were additional performance obligations within the contract unrelated to the delivery of pharmaceutical products, the variable consideration for product returns would not be allocated amongst all performance obligations, as it relates only to the product delivery performance obligation. However, if variable consideration was recognized for prompt payment discounts, that likely should be allocated amongst all identified performance obligations as it relates to the sale transaction as a whole. 

Complexities encountered when applying ASC 606 

The application of ASC 606 can add complexity to accounting for many organizations within the life sciences industry. Life sciences organizations typically enter into complex contracts, making the ongoing application of ASC 606 more challenging. Life sciences organizations must exercise judgment in determining if their contracts fall within the scope of ASC 606 and in their selection and application of methods to estimate variable consideration.  

This article addresses just a few examples of complexities that may be encountered when applying ASC 606 to contracts by life sciences companies; there are many more circumstances that could create potential pain points. It’s advisable to identify potential issues or uncertainties early and engage a trusted advisor to assist, when necessary, in navigating the provisions of the standard.