Published by: Amper, Politziner & Mattia

By now, most life sciences company CFOs and Controllers should be fully aware of the primary revenue recognition criteria as established by the Securities Exchange Commission (SEC). And we all realize that revenue recognition continues to be a Critical Accounting Policy for all companies. In the SEC’s Staff Accounting Bulletin (SAB) 101/104, the commission established the four major criteria for revenue recognition, which are: that persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price is fixed or determinable, and collectibility is reasonably assured.

While everyone has adopted this guidance, there are countless other accounting pronouncements which govern the manner in which revenue should be recognized. The subtleties of revenue recognition, critical to any organization’s financial reporting, are dependent upon many factors, including the industry in which the company operates. The following are highlights of revenue recognition subtleties that affect the life sciences arena and can frequently be overlooked.

Multiple Element Arrangements
In accounting, certain contracts are deemed to have multiple elements. The current accounting literature requires that such elements are separated and recognized separately based upon standard revenue recognition guidance. A common example of this type of an arrangement can be found in licensing agreements, where companies will license compounds or products, provide for clinical support agreement, and provide for a royalty stream once approved for commercialization. When all of these revenue streams are combined into one, for accounting purposes they must be separated. The difficulty results from the requirement to recognize each element at its “fair value”, which may or may not be consistent with the explicit licensing terms. Further, developing documentation to support these “fair values” is often difficult given the uniqueness of each licensing agreement, although there are some industry norms which may provide guidance.

Upfront Fees
Many times in the life sciences licensing arena, organizations charge a one-time, non-refundable, up-front fees. In accordance with Staff Accounting Bulletin #101/104 by the Securities and Exchange Commission, “up-front fees, even if nonrefundable, are earned as the products and/or services are delivered and/or performed over the term of the arrangement or the expected period of performance and generally should be deferred and recognized systematically over the periods that the fees are earned.” In essence, if a company charges an up-front fee, the revenue generated from this fee should be deferred and recognized over the period of the average customer life.

Other milestone fees paid to the licensee are often recognized upon successful clinical outcome, however, in certain instances, these fees (even if non-refundable) may be required to be deferred if the milestone payment is the subject of a multiple element agreement or all of the revenue recognition criteria have not been met.

Product sales
Sales of products in the life sciences industry are often subject to deductions, which require quantification and recognition at the time of sale. It is essential that companies maintain careful records to support its assumptions and calculations of these sales deductions.
The principal areas where such deductions occur include:

* Chargebacks from wholesalers
* Rebate and discount programs
* Returns

The topic of channel stuffing has also received significant attention, thereby requiring companies to analyze whether very significant sales transactions are reflective of a completed economic transaction. To the extent the transaction is reflective of channel stuffing, the revenue may not be recognizable.

Conclusion
The accounting guidance surrounding revenue recognition is highly complex and requires diligent and careful analysis. The subtleties and pitfalls outlined above are only a few of the many areas that should be closely examined. Organizational management, including non-accounting personnel, should periodically review revenue recognition policies internally to ensure continuing compliance. It is also advised to consult with external accountants to review new contractual arrangements and modifications to existing arrangements to ensure proper revenue recognition.

John Pennett is an Officer and Director of the Life Sciences Practice at Amper, Politziner & Mattia.