The new revenue recognition standard for life sciences companies

The new revenue recognition standard for life sciences companiesHosted by EY Global Life Sciences

15 June 2015

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Scott BrunsErnst & Young LLPPartner, Global Life Sciences Assurance Leader

Today’s moderator

The new revenue recognition standard for life sciences companies

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Today’s presenters

Derek KostiInternational Controller for Pfizer’s Worldwide Biopharmaceuticals Business

Tim GordonEY Global Life Sciences Financial Accounting Advisory Services Leader

Frederik SchmachtenbergEY Global Life Sciences Assurance Resident

The information contained herein is a summary in nature. Viewers should consult their own professional advisors to address their individual circumstances and concerns.


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Agenda

► The 5-step model

► Applying the 5-step model: life sciences industry-specific examples

► Implementation considerations


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► Core principle: recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services

Applying the new standard: the 5-step model

Step 1: Identify the contract(s) with a customer

Step 2: Identify the performance obligations in the contract

Step 3: Determine the transaction price

Step 4: Allocate the transaction price to the performance obligations

Step 5: Recognize revenue when (or as) each performance obligation is satisfied


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Agenda





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Example 1:► Biotech out-licenses the rights to an investigational compound in

phase II and will perform R&D services to Pharma► Biotech receives an upfront nonrefundable payment of $50 million,

and R&D services are billed at an agreed upon FTE rate► Assume for this example, that the license and the R&D services are

capable of being distinct (e.g., the R&D services provided by Biotech are not considered complex and could be performed by others in the market)

► Question: Are the license and the R&D services distinct in the context of the contract (i.e., separate performance obligations)?

Distinct within the context of a contract(Part of Step 2: identify performance obligations)


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Distinct within the context of a contract(Part of Step 2: identify performance obligations)

Distinct within the context of a contractBoth Boards Clarify when a promised good or service is “separately identifiable” from other

promises in a contract (i.e., distinct within the context of the contract)

FASB (May 2015 Exposure Draft)

Three-part change:1. Refine the principle for determining distinct within the context of the contract

(i.e., whether the multiple promised goods or services work together to deliver a combined output)

2. Align this principle with the standard’s three indicators for determining when a good or service is not separately identifiable: (1) the entity is using the goods or services as inputs to produce or deliver the combined output or outputs specified by the customer; (2) one or more of the goods or services significantly modifies or customizes one of the other goods or services; (3) goods or services are highly interdependent or highly interrelated

3. Add examples

IASB (tentative decisions) Add examples


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Example 2:► Pharma sells a product to a public hospital in a country that is in

financial difficulties in connection with the sovereign debt crisis► Pharma has a history of delays in receipt of payment for sales due to

poor economic conditions► On average, Pharma has days sales outstanding of 500 days and

typically receives $0.70 per dollar of the initial sales price► Further assume that Pharma deems collection probable for $0.70 per

dollar of the initial sales price and the other criteria in Step 1 (as part of assessing the attributes of a contract) have been met

► Question: What should be considered when evaluating whether revenue would be recognized under: (1) Current US GAAP and IFRS?(2) ASC 606/IFRS 15?

Variable consideration – price concessions(Part of Step 3: determine the transaction price)


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Example 2 (continued):

Variable consideration – price concessions(Part of Step 3: determine the transaction price)

Current US GAAP and IFRS ASC 606/IFRS 15• Pharma would need to determine

whether collectibility is reasonably assured (US GAAP)/if it is probable that the economic benefits will flow to the entity (IFRS)

• If those criteria are not met, Pharma would need to defer revenue recognition until payments from the customer are received, assuming the other basic revenue recognition criteria have been met

• If Pharma is aware of potential collectibility issues at the onset of the contract, but is still willing to enter into the contract, the arrangement may include implied price concessions. Under the new standard implied price concessions are considered variable consideration and should be reflected in the estimated transaction price.

• Once determined, the transaction price is allocated to the performance obligations and recognized as revenue as control of the product transfers to the customer


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phase II and will perform R&D services for Pharma► Biotech receives an upfront nonrefundable payment of $50 million,

and R&D services are billed at an agreed upon FTE rate► Assume for this example that the license and R&D services

are distinct► Question: How should the amount of the transaction price allocated to

the license be recognized?

Nature of promise in granting a license of Intellectual Property (IP) (Part of Step 5: recognize revenue)


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Nature of promise in granting a license of IP(Part of Step 5: recognize revenue)

* Unless the functionality of the IP is expected to substantively change as a result of activities performed by the entity that do not transfer a good or service and the customer is contractually or practically required to use the updated IP

The nature of an entity’s promise in granting a license of IP

Both Boards (May 2015 FASB ED; IASB tentative decisions)

• Activities performed by the licensor that affect the “utility” of the IP revenue recognized over time• Utility = the IP’s ability to provide benefit or value

• If IP has significant standalone functionality, licensor’s activities will not significantly affect a substantial portion of the utility of the IP revenue recognized at a point in time

FASB (May 2015 ED)

IP will be classified into one of two categories:• Functional (revenue recognition at a point in time*): IP would have

standalone functionality (e.g., drug formulas, biological compounds)• Symbolic (revenue recognition over time): IP would not have standalone

functionality (e.g., brands, trade names, logos)

IASB (tentative decisions)

• Only minor wording changes to expand on the principles in the new standard

• Will not include a requirement to classify licenses of IP as either functional or symbolic

The Boards agreed that both of their approaches generally would result in consistent answers.


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phase II and will perform R&D services for Pharma► Biotech receives an upfront nonrefundable payment of $50 million,

and a quarterly payment for R&D services that are billed at an “at market” FTE rate. Biotech is eligible to receive a 5% royalty on all sales of a commercialized product.

► Assume for this example, that the license and R&D services are distinct and that the stand-alone selling price of the license is the $50 million upfront payment plus the 5% royalty rate

► Question:► When should the 5% royalties revenue be recognized?

Sales- and usage-based royalties exception(Part of Step 5: recognize revenue)


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Sales- and usage-based royalties / other license issues(Part of Step 5: recognize revenue)

Sales- and usage-based royalties

Both Boards (May 2015 FASB ED; IASB tentative decisions)

• The sales-based royalty exception would be applied to the overall royalty stream when the predominant item to which the royalty relates is the license of IP

• A sales-based royalty would not be partially in the scope of the sales-based royalty constraint guidance and partially in the scope of the general variable consideration constraint guidance

Other license issues

FASB (May 2015 ED)

• An entity would need to consider the licenses guidance when determining the pattern of revenue recognition for a combined performance obligation that includes a license

• Restrictions of time, geographical region or use do not define whether a performance obligation is satisfied at a point in time or over time or affect how many goods or services are promised in the contract

IASB (tentative decisions)

• No changes• Existing guidance is sufficient


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Agenda





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‘We don’t think there will be significant changes so why should we do anything?’► Detail► Documentation► Disclosure

Impact and challenges of the new standard


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Customers

Impact and challenges of the new standard

Patient

Physician

Hospital

GPO

Pharmacists

Wholesalers

Specialty distributors

Supermarkets

Government agency

Competitors

Contract type/terms

Licenses

Direct to consumer

Return rights

Variable consideration

Rebates

Outcome based

Cost sharing

Milestones

CRO agreements

GeographyProducts

Products

Portfolio of products


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Performing a diagnostic will enable you to:► Identify relevant revenue streams and

“unique” contracts► Understand high-level financial and

existing in-progress project effects► Decide on a transition method► Prepare a detailed planning budget to

understand the level of resources required

► Navigate stakeholder questions regarding changes and effects

Action planning and next stepsWhy start a diagnostic now?


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Practical challenges and questions

How to start the assessment process?► Team –

internal/external, central/decentralized, expertise needed?

► Education sessions –how broad?

► Use of questionnaire/ surveys – how deep?

What operational changes are we expecting to see?► Changes to current

contracts?► More people outside of

finance that need to be technically trained?

► System changes?

Challenges during the process?► What market coverage

is appropriate?► How many contracts

should be reviewed?► How much

documentation is enough?

► Use of tools?


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Action planning and next stepsBefore 31 December 2015

Must:

► Read the standard and understand the accounting implications

► Communicate results internally and with other stakeholders

► Understand what the industry is doing

Should:

► Appoint a project lead and cross functional team

► Educate the accounting and commercial teams

► Identify revenue streams and survey pilot markets

► Decide on a preferred transition method

► Consider the tax and systems implications

Could:

► Identify the financial effects

► Understand the disclosure requirements

► Develop a data collection plan

► Revise accounting and procedural policies


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EY resources

► EY Revenue Recognition Readiness tool► Recent IFRS EY publications (visit ey.com/IFRS)

► Applying IFRS: A closer look at the new revenue recognition standard (June 2014)► Applying IFRS in Life Sciences: The new revenue recognition standard – life

sciences (November 2014)► Applying IFRS: Joint Transition Resource Group for Revenue Recognition items of

general agreement (May 2015)

► Recent US GAAP EY publications (visit ey.com/accountinglink) ► Technical Line, A closer look at the new revenue recognition standard (June 2014)► Technical Line, The new revenue recognition standard — life sciences (August

2014)► Joint Transition Resource Group for Revenue Recognition items of general

agreement (April 2015)► To the Point, FASB proposes first round of amendments to its’ new revenue

recognition standard (May 2015)


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Scott Bruns, Global Life Sciences Assurance [email protected]+1 317 681 7229

Tim Gordon, EY Global Life Sciences FAAS [email protected]+1 212 773 6938

Frederik Schmachtenberg, EY Global Life Sciences Assurance [email protected]+1 312 879 5026

EY contact information


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Disclaimer► These slides are for educational purposes only and are not intended, and should not be

relied upon, as accounting advice.► This presentation is provided solely for the purpose of enhancing knowledge on tax

matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer’s facts and circumstances.

► The views expressed by the presenters are not necessarily those ofErnst & Young LLP.

► This presentation is © 2015 Ernst & Young LLP. All Rights Reserved.

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