By Ryan Starkes, partner and leader of the Life Sciences practice, BDO USA, Patrick Hunnius, senior counsel, DLA Piper, and Jennifer Feldman, counsel, DLA Piper
Whether you’re ready or not, significant accounting changes are coming, and they aren’t just a problem for your auditor. For life sciences companies considering a merger, acquisition, or strategic partnership in the near future, an understanding of the new standard for revenue recognition (i.e., what month earnings are reported on the financial statement) and its potential impact on deal structures will be critical.
A year ago, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (collectively, the Boards) announced a long-awaited new standard for revenue recognition that replaces existing U.S. generally accepted accounting principles (GAAP). The impact is likely to be far reaching, across all industries, and as a result, implementation questions are mounting. Indeed, the FASB is exploring a possible delay in the implementation date. Still, life science executives cannot afford to sit back and ignore the standard until final guidance is in place.
Revenue recognition in the life sciences industry is particularly complex, because companies typically have revenue streams not only from the direct sale of drugs or medical devices, but also from licensing and other arrangements from third parties who assist in the process of bringing products to market. How exactly the new standard will be applied to each revenue stream is a subject for another article, but it is important to note that previous guidance on certain forms of revenue are superseded by the new rules. Despite the breadth and significance of these changes, a recent poll by BDO of 200 CFOs found that over half had not yet familiarized themselves with the new standard.
This is not entirely surprising given that there are around 700 pages of guidance to sort through. However, companies will likely have an additional year to adopt the new rules as FASB recently proposed a delay in the effective date, pushing back the deadline to 2018 for public companies and 2019 for private companies. Meanwhile, other companies are in the process of planning for a full retrospective adoption. In addition, the FASB is continuing to refine the standard through formal amendments based on implementation issues raised by stakeholders, specifically regarding license arrangements. In other instances, the FASB’s Transition Resource Group (TRG) may discuss an implementation issue and conclude that preparers can interpret the standard consistently with respect to that issue. When this occurs, the TRG may decide that further changes to the standard are not necessary. The discussion papers for these issues are available on the FASB’s website and might be useful for life sciences companies that are analyzing the impact of the new revenue rules.
IMPACT ON REVENUE STREAMS
With the new standard fast approaching, life sciences companies should be proactive in considering the new standard and whether or how it affects their current revenue recognition analyses and policies. Specific sources of revenue for life sciences companies should be assessed in light of the new standard, such as licensing agreements, variable consideration, and reseller agreements.
- Licensing of Intellectual Property: Under the new standard, life sciences companies will need to determine whether a particular license provides a right of access or a right to use the underlying IP. If a license provides a right to use the company’s IP, then the revenue is recognized at the point in time the license transfers to the customer. The Boards are developing guidance to make the access vs. use judgment easier for companies to apply.
- Variable Consideration: Under the new standard, companies may be able to recognize a portion of revenue from revenue streams such as bonuses and milestone payments before milestones are achieved, when the risk of failing to meet those milestones is low.
- Reseller Agreements: Under the new standard, companies might be able to recognize revenue when a product is transferred to the reseller once they have enough experience to estimate variable components of pricing such as returns and chargebacks.
IMPACT ON LIFE SCIENCES INDUSTRY DEALS
Life sciences companies continue to see a great deal of interest from investors, public markets, and strategic buyers. The hot IPO market has added new potential takeover targets to the mix, according to Bloomberg, and in the first month of the year there were five deals with headline values of $1 billion or more, according to PMLive. In March, AbbVie made headlines with a $21 billion deal to acquire Pharmacyclics. With the market ripe for transactions, life science executives need to consider how the new standard can and should impact the deal structure.
Transaction values are typically predicated on the “potential” market (i.e., revenues) for products in development, and forecasting the timing of cash flows from related licenses and other arrangements, and the recognition of revenue is critical. The new revenue recognition standard brings potential changes to how revenue from each of these sources is recognized. Public life sciences companies are properly disclosing in 10-Qs and 10-Ks that they are aware of the new standard and are evaluating the potential impact, if any. The SEC expects that companies will be going through a more thorough review process over the next year to provide better guidance on the impact.
While a more thorough review of the new standard may be on the horizon for many life sciences companies, a transaction could force a company to expedite its analysis of several revenue recognition issues. For example, consider a transaction where a company agrees to pay royalties on future products. Traditionally, the language in this type of arrangement will reference revenues in accordance with U.S. GAAP. But if one party is treating revenue under legacy U.S. GAAP and the other is complying with the new standard, what “revenue” means could be very different to each company. For companies considering a deal in the coming months, the lack of clarity about implementation dates and potential changes in the standard, coupled with a transition period where some companies have adopted and some have not, is creating a host of challenges.
The new standard brings potentially wide-reaching changes for how life sciences companies recognize revenue and a resulting impact on deal structure. Companies should consider an assessment of how the standard will affect them and any corresponding changes in accounting policies or internal controls that may be required. Companies should also consider monitoring discussions of the SEC and the Boards on these changes. Looking at this proactively will allow companies to be in the best position possible when facing a potential industry deal amidst the changing standard.