New Developments Summary

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1 December 10, 2014 NDS New Developments Summary Life sciences the new revenue standard ASU shifts the top line Summary The volume of health care needs our population faces requires innovation across a broad range of product and service offerings that is constantly evolving due to breakthroughs in science and medical research. The new revenue recognition guidance contained in the FASB s Accounting Standards Update (ASU) and in the IASB s IFRS 15, both titled Revenue from Contracts with Customers, creates a new, principle-based revenue recognition framework that affects nearly every revenue-generating entity, including life sciences arrangements. ASU creates a new topic in the FASB Accounting Standards Codification (ASC or Codification), Topic 606. In addition to superseding and replacing nearly all existing U.S. GAAP revenue recognition guidance, including industry-specific guidance, ASC 606 Establishes a new control-based revenue recognition model Changes the basis for deciding when revenue is recognized over time or at a point in time Provides new and more detailed guidance on specific topics Expands and improves disclosures about revenue In addition, ASU adds a new Subtopic to the Codification, ASC , Other Assets and Deferred Costs: Contracts with Customers, to provide guidance on costs related to obtaining a contract with a customer and costs incurred in fulfilling a contract with a customer that are not within the scope of another ASC Topic. The guidance in ASU is effective for public entities for annual reporting periods beginning after December 15, 2016, including interim periods therein. Nonpublic entities are required to apply the guidance for annual periods beginning after December 15, 2017 and for interim and annual reporting periods thereafter. Early application is not permitted for public entities. A nonpublic entity may apply the guidance as early as annual reporting periods, and interim periods within those years, beginning after December 15, This bulletin explains the key features of ASC 606 and provides practical insights into its application and impact on the life sciences industry. The FASB and the IASB have formed the Joint Transition Working Group for Revenue Recognition (TRG), which will meet quarterly to discuss implementation issues. The TRG will not issue guidance. In

2 New Developments Summary 2 addition, the AICPA has formed 16 industry task forces to address implementation issues. As a result of the ongoing implementation activities, the views expressed in this document are preliminary and may change as we evaluate, and entities begin to apply, the guidance and related interpretations. Contents A. Overview... 2 B. Scope... 3 C. The five steps to the revenue recognition model... 4 Step one: Identify the contract with a customer... 4 Step two: Identify the performance obligations... 9 Customer options Implied obligations Step three: Determine the transaction price Variable consideration Significant financing components Noncash consideration Consideration payable to a customer Step four: Allocate the transaction price to the performance obligations Step five: Recognize revenue Licensing arrangements D. Other topics Consignment and distribution arrangements Product warranties Contract costs E. Presentation and disclosure F. Effective date and transition A. Overview After more than 10 years of work on the project, the FASB and the IASB have published their new, converged standards on revenue recognition. The FASB issued ASU , Revenue from Contracts with Customers, and the IASB issued IFRS 15 with the same title. The guidance in ASU , which is codified in the new Topic 606 in the FASB Codification, supersedes and replaces virtually all existing U.S. GAAP revenue recognition guidance, including industry-specific guidance, and affects almost every revenue-generating entity that applies U.S. GAAP. For entities in the life sciences industry, ASC 606 supersedes the guidance in ASC , Revenue Recognition: Multiple Element Arrangements; ASC , Revenue Recognition: Milestone Method; and ASC , Revenue Recognition: Rights to Use. ASU creates a single, principle-based revenue recognition framework that requires entities to shift away from primarily rules-based U.S. GAAP and to apply significantly more judgment. With that increase in judgment, ASC 606 also requires expanded disclosures surrounding revenue recognition. Although the new guidance is not effective for more than two years, all entities must apply ASC 606 once it is effective, even though not every entity will experience a significant change in the top-line revenue amount. Accordingly, all entities should begin their impact assessment now to enable them to determine what changes to systems, processes, and policies are needed to implement ASC 606 and how to communicate the impact of the new guidance to stakeholders. In the life sciences industry, contracts that may be most impacted by the new revenue standard include multiple-element arrangements;

3 New Developments Summary 3 collaborative research arrangements; contracts with variable consideration, such as milestone payments, royalties, rebates, price protection, volume discounts, and additional purchase options; intellectual property licenses; and distributor and consignment arrangements. B. Scope ASC 606 applies to contracts with customers to provide goods or services. It does not apply to certain contracts within the scope of other ASC Topics, such as lease contracts, insurance contracts, financing arrangements, financial instruments, guarantees other than product or service warranties, and nonmonetary exchanges between entities in the same line of business to facilitate sales to customers. A contract with a customer may be partially within the scope of ASC 606 and partially within the scope of other ASC Topics. If the other Topics specify how to separate and/or measure a portion of the contract, then that guidance should be applied first. The amounts measured under other Topics should be excluded from the transaction price that is allocated to performance obligations under ASC 606. If the other Topics do not stipulate how to separate and/or measure a portion of the contract, then ASC 606 should be used to separate and/or measure that portion of the contract. For example, in the life sciences industry, a contract including both the sale of a medical device as well as a lease of a specialized machine to power the device would be partly within the scope of ASC 606 and partly within the scope of ASC 840, Leases. ASC (b), as amended in ASU , although requiring payments and other consideration to be separated into those for the lease and those for other services, does not directly provide guidance on allocating the transaction price, but instead refers to the method of allocating the transaction price to performance obligations included in ASC through 41. ASC 606 defines a customer as 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. A counterparty to the contract might not be a customer if, rather than obtaining an output of the entity s ordinary activities, the contract calls for the counterparty to participate with the entity in an activity or process (such as developing an asset) and the parties share in the risks and benefits resulting from that activity or process. Therefore, an entity that enters into such arrangements for collaborative research and development (R&D) activities will need to evaluate the particular facts and circumstances of each contract, including its purpose, to determine if the counterparty is a customer. ASC 606 does not apply to transactions with entities that do not meet the definition of a customer, such as certain collaborative arrangements within the life sciences industry. While many collaborative arrangements may be excluded from the scope of the new standard, judgment is required in determining whether a transaction is in effect an arrangement with a customer and is therefore within the scope of ASC 606. Contracts not within the scope of ASC 606 should continue to be accounted for using existing guidance. Practical insight: Identifying the customer Entities might find it challenging to determine which party is the customer in an arrangement involving multiple parties. Furthermore, some transactions among partners in certain collaborative arrangements are excluded from the scope of ASC 606 because the counterparty to the arrangement is not obtaining an output of the entity s ordinary activities. The FASB and IASB have not provided implementation guidance on how to determine whether a counterparty is considered a customer. We believe that an entity should consider qualitative factors, including its strategy and objectives, in making this determination, particularly for entities whose principal ordinary activity is developing technology to sell or license to others. In a contract requiring R&D services, the development may be part of the entity s ordinary

4 New Developments Summary 4 activities, and the entity may conclude that the arrangement is with a customer. In contrast, if the entity does not provide R&D services as part of its ordinary activities, a collaborative arrangement would most likely be outside the scope of ASC 606. The guidance in ASU should be applied to an individual contract with a customer. However, an entity is permitted a practical expedient to apply the guidance to a portfolio of contracts (or performance obligations) with similar characteristics, provided that the entity reasonably expects that the financial statement effects of applying the guidance at the portfolio level would not be materially different from applying the guidance to the individual contracts (or performance obligations) within the portfolio. However, ASU does not provide any specific guidance on how to make that assessment. If using a portfolio approach, an entity should consider the size and composition of the portfolio in developing estimates and assumptions. C. The five steps to the revenue recognition model Applying the core principle of the new revenue recognition model involves the following five steps: 1. Identify the contract with a customer. 2. Identify the performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations. 5. Recognize revenue. Identify the contract with the customer Identify the performance obligations Determine the transaction price Allocate the transaction price Recognize revenue Step one: Identify the contract with a customer Because the guidance in ASC 606 applies only to contracts with customers, the first step in the model is to identify those contracts. A contract is defined as an agreement between two or more parties that creates enforceable rights and obligations. A contract can be written, oral, or implied by an entity s customary business practices. In addition, the guidance in ASC 606 applies only to arrangements that meet all of the following criteria: The parties have approved the contract, which creates enforceable rights and obligations. The entity can identify each party s rights. The entity can identify the payment terms for the goods or services. The contract has commercial substance. It is probable that the entity will collect the consideration to which it will be entitled.

5 New Developments Summary 5 When evaluating the probability of collectibility, an entity should assess only the customer s ability and intention to pay the amount of consideration when it is due. In addition, in determining the consideration to which it will be entitled, an entity needs to evaluate at contract inception whether it expects to provide a price concession that will result in it receiving less than the full contract price from the customer. Practical insight: Existence of a contract Step 1 serves as a gate through which an entity must pass before proceeding to the later steps of the model. In other words, if at the inception of an arrangement, an entity concludes that the criteria discussed above are not met, it should not apply Steps 2 through 5 of the model until it determines that the criteria for Step 1 are subsequently met. Significant judgment may be required to conclude whether a contract meets this criteria. If an entity determines at the arrangement s inception that one or more of the specified criteria above have not been met, it should reassess whether the criteria are subsequently met. An entity that receives consideration from a customer before meeting all of the above criteria cannot recognize revenue until the criteria above are subsequently met or either of the following conditions occurs: The entity has completed the performance under the contract, and all, or substantially all, amounts have been received from the customer and are nonrefundable. The arrangement is canceled, and amounts received from the customer are nonrefundable. In some circumstances, the guidance on accounting for contracts when the criteria for Step 1 are not met may result in a delay in recognizing revenue compared to the guidance under existing U.S. GAAP. For example, under ASC 606, if a contract does not meet the criteria above, an entity is required to recognize a liability for nonrefundable amounts received in an arrangement when performance is not complete, whereas under existing GAAP, an entity may be permitted to recognize revenue in the amount of cash received. Practical insight: Collectibility The new guidance regarding collectibility is somewhat similar to current U.S. GAAP. However, an entity currently evaluates collectibility when revenue is recognized, while under ASC 606, an entity evaluates collectibility in Step 1, when it determines whether a contract exists. Under ASC 606, an entity needs to assess whether collectibility is probable before it applies Steps 2 through 5 and recognizes any revenue. This threshold is slightly higher than the reasonably assured guidance in SEC Staff Accounting Bulletin Topic 13, Revenue Recognition. Another difference between the new guidance and existing U.S. GAAP relevant to the life sciences industry is that ASC 606 explicitly requires an entity to consider whether the transaction price is variable because the entity may offer the customer a price concession before determining that collectibility is probable. If the entity concludes that a price concession is likely, it would evaluate whether collectibility of the transaction price after the concession is probable.

6 New Developments Summary 6 Combining contracts An entity should combine two or more contracts and account for them as a single contract if they are entered into with a single customer (or related parties) at or near the same time and if they meet at least one of the following criteria: The contracts are negotiated as a package with one commercial objective. The amount paid under one contract depends on the price or performance under another contract. The goods or services to be transferred under the contracts constitute a single performance obligation (see Step 2: Identify the performance obligations ). Practical insight: Combining contracts The guidance in ASC 606 on combining contracts is similar to current U.S. GAAP, except for one important distinction. Current guidance includes indicators for an entity to consider in evaluating whether two or more contracts should be combined. In contrast, ASC 606 requires that an entity combine contracts that were entered into at or near the same time if they meet any of the stated criteria. As a result, an entity needs to determine what constitutes at or near the same time, as well as develop processes on how to evaluate whether the criteria are met. In many situations, the criteria related to whether the performance obligations or payments in multiple contracts are interdependent will be a more straightforward evaluation; however, because ASC 606 is principle-based, many entities might find that significant judgment is required in certain circumstances in determining whether multiple contracts are negotiated with a single commercial objective in mind or whether the goods and/or services under those contracts constitute a single performance obligation. Although combining contracts is not common in the life sciences industry, entities still need to consider whether they have multiple contracts with a customer and whether contracts entered into at or near the same time should be combined. Contract modifications A contract modification results when the parties to a contract approve a change in the scope and/or the price of a contract (in other words, new enforceable rights and obligations exist or changes are made to those previously existing). Several possibilities exist for changes in price or scope. For example, the parties may agree on scope but not price changes, or they may have a dispute regarding the price or scope. When the parties have approved a change in scope but the corresponding price has not yet been determined, the entity should use the variable consideration guidance (discussed in Step 3 below) to evaluate the relevant facts and circumstances in estimating the change in transaction price arising from the modification. Similar to approval of the original contract, approval of a modification could be made orally or in writing or could be implied by customary business practice.

7 New Developments Summary 7 Accounting for contract modifications Is contract modification approved? No Account for the original contract only until the modification is approved Yes Does it add distinct goods or services? Yes Do the additional goods or services reflect the entity's current stand-alone selling prices? Yes No No Account for modification as part of the original contract (cumulative catch up basis) Account for the modification as a separate contract Account for as a termination of existing and creation of a new contract An entity accounts for a modification as a separate contract, which affects only future revenues, if the modification results in both of the following conditions: The scope increases to reflect additional promised goods or services that are distinct, as defined (see Step 2: Identify the performance obligations ). The additional consideration to the seller reflects the added goods or services stand-alone selling prices and any appropriate adjustments based on the circumstances. If a contract modification is not considered a separate contract, there are three potential outcomes. An entity would evaluate the remaining goods and services to be delivered under the modified contract to determine how to account for the modification, as follows: If the remaining goods or services are distinct from those delivered before the contract was modified, the entity treats the modification as a termination of the original contract and the creation of a new contract. As such, the amount of consideration allocated to the remaining separate performance obligations equals the sum of the estimated transaction price (including amounts already received from the customer) not yet recognized as revenue, plus the amount of consideration arising from the modification. If the remaining goods or services are not distinct and are part of a single performance obligation that is partially satisfied as of the modification date, the entity treats the modification as part of the original contract by adjusting the transaction price and remeasuring its progress toward completion of the

8 New Developments Summary 8 performance obligation. The revenue recognized to date should be increased or decreased for the effects of the contract modification on a cumulative catch-up basis. If the modification represents a combination of the two preceding scenarios, the entity should use a combination of the two methods above. Practical insight: Contract modifications The scope, duration, or price of R&D services required in an arrangement are periodically modified based on research findings or other factors. The determination of how a modification is accounted for depends on whether the R&D services in the modified contract are considered distinct from the R&D services already provided or other elements (for example, a license) in the original contract, and whether the additional services are priced commensurate with their stand-alone selling price. Example Company A, whose ordinary activities include R&D services, enters into a five-year contract to perform these services for Company B for $250,000 per full-time equivalent (FTE) basis per year. For purposes of this example, assume that company A utilizes one full-time scientist to perform these R&D services. The stand-alone selling price of the R&D services at contract inception is $250,000 per year per FTE. Company A recognizes revenue of $250,000 per year during the first three years of providing services. At the end of the third year, the contract is modified as follows. The contract is extended for five additional years (for a total contract length of ten years), and the price is adjusted to $300,000 per FTE beginning in year six. The remaining two years under the original contract term are at the original rate of $250,000 per FTE. The total remaining compensation under the modified contract is $2,000,000 ($250,000 x 2 years + $300,000 x 5 years). The stand-alone selling price of the services at the beginning of the third year is $325,000 per FTE per year. How should this modification be accounted for? Company A accounts for the R&D agreement as a single performance obligation because the services are a series of distinct services that are substantially the same and have the same pattern of transfer to the customer (that is, the services transfer to the customer over time). The R&D services provided under the modified agreement include additional services that are distinct from those already transferred. However, the amount of remaining consideration to be paid does not reflect the stand-alone selling price of the required additional services. As a result, Company A should account for the modification in accordance with ASC (a) as a termination of the original contract and the creation of a new contract, with revenue recognized each year for $285,714 ($2,000,000/7 for the remaining 7 years) as the R&D services are provided.

9 New Developments Summary 9 Step two: Identify the performance obligations Having identified a contract, the entity next identifies the performance obligations within that contract. A performance obligation is defined as a promise in a contract with a customer to transfer either (1) a good or service, or a bundle of goods or services, that is distinct (see below), or (2) a series of distinct goods or services that are substantially the same and have the same pattern of transfer to the customer. Performance obligations are normally specified in a contract, but also may include promises implied by an entity s customary business practices, published policies, or specific statements that create a valid customer expectation at contract inception. Performance obligations exclude activities that do not result in the transfer of a good or service to the customer (for example, some set-up activities). Under ASC 606, a promised good or service is considered distinct if both of the following criteria are met: The customer can benefit from the good or service either on its own or with other resources readily available to the customer. A readily available resource is a good or service that is sold separately (by the entity or by another entity) or one that the customer has already obtained (from the entity or from other events or transactions). The promise to transfer a good or service is separable from other promises in the contract. The following factors indicate that a good or service is separable from other goods or services in the contract: The entity does not provide significant integration services. Stated differently, the entity is not using the good or service as an input to produce the specific output called for in the contract. The good or service does not significantly modify or customize other promised goods or services in the contract. The good or service is not highly dependent on, or interrelated with, other promised goods or services in the contract. For example, a good or service might not be highly interrelated if a customer can decide not to purchase a particular good or service and if that decision does not significantly affect other promised goods or services under the contract. Examples: Identifying performance obligations Example 1 Assume that a biotechnology company (BioCo) enters into a licensing arrangement with a pharmaceutical company (PharmaCo) whereby BioCo grants PharmaCo the right to certain intellectual property (IP) for an early stage drug under development in exchange for a nonrefundable payment. In addition to the licensing arrangement, BioCo will perform certain R&D services for PharmaCo for an annual fee due to the early stage of the development process. The up-front amount payable for the licensing agreement is not contingent on the outcome of any future R&D activities. We believe that the stage of development of the licensed IP impacts the assessment of whether the license in this example would qualify as distinct. During early development or preclinical stages, BioCo may possess specific knowledge and skills that could prevent other parties from

10 New Developments Summary 10 performing the R&D services. If the license is not distinct, then it should be combined with the R&D services as a single performance obligation. Example 2 BioCo licenses rights for an approved drug compound to PharmaCo for 10 years and also promises to manufacture the drug for PharmaCo. The drug is an established product, so BioCo will not undertake any development activities to support the drug. No other entities can manufacture this drug because of the highly specialized nature of the manufacturing process. As a result, it is not feasible to purchase a license to use this drug separately from the manufacturing services. Based on these facts, BioCo concludes that PharmaCo cannot benefit from the license without the manufacturing service; therefore, the license and manufacturing services are not considered distinct, and BioCo would account for the contract as a single performance obligation. Example 3 Assume the same facts as in Example 2, except that the manufacturing process is not specialized, meaning that several other companies can also manufacture the drug for PharmaCo. BioCo concludes that PharmaCo can benefit from the license on its own and that the license is separately identifiable from the manufacturing process because the manufacturing process can be provided by others. Therefore, BioCo identifies two separate performance obligations: License rights Manufacturing services Customer options A contract may provide a customer with an option to purchase additional goods or services at an incremental discount that would not have been offered if the customer had not entered into the original contract. If the option grants the customer a material right, then the seller in the original contract is effectively requiring the customer to pay in advance for future goods or services. The new standard requires entities to account for this material right as an additional performance obligation, with revenue for the material right being recognized when the future goods or services are purchased or when the option expires. For example, if a customer enters into a contract and receives a 25 percent discount on future purchases (not to be combined with other offers) and the entity typically provides a 10 percent discount to other customers for stand-alone sales, then the incremental 15 percent provided would represent the material right of the option, and only that amount would be considered when determining the stand-alone selling price or when allocating consideration (see Steps 3 and 4 of the model). Implied obligations Entities may provide performance obligations to customers that are not explicitly described in a written contract but are implied based on past transactions or customary practice. To identify whether any implied performance obligations exist, entities should consider other transactions that are similar in nature, including transactions with the same customer, as well as other information available to

11 New Developments Summary 11 customers (such as public advertisements, posted policies, oral statements, or industry standards) that may indicate implied promises that result in performance obligations to the customer. Practical insight: Material rights A medical device company (MedCo) enters into a contract with a customer for the sale of 25 units of a new offering, Product A, for $100 per unit, which represents a 10% discount from list prices and is the stand-alone selling price offered to all customers. As part of the contract, MedCo gives the customer a 25% discount voucher for any future purchases up to $2,000 in the next 90 days. The 10% discount cannot be used in addition to the 25% discount voucher. The incremental 15% discount (25% minus 10%) provides the customer with a material right. MedCo should account for the promise to provide the incremental discount as a performance obligation in the contract for the sale of Product A. To estimate the stand-alone selling price of the discount voucher, MedCo needs to consider the following factors: Discounts the customer could receive without making the original purchase (for instance, discounts generally available to all customers) The likelihood that additional purchases will be made using the discount voucher MedCo estimates that there is a 50% likelihood that a customer will redeem the voucher and that a customer will, on average, purchase $1,000 of additional products. The estimated stand-alone selling price of the discount voucher is $75 ($1,000 average purchase price of additional products x 15% incremental discount x 50% likelihood of exercising the option). The stand-alone selling prices of Product A and the discount voucher are summarized below. Stand-alone selling prices: Performance obligation Product A Stand-alone selling price $2,500 ($100 per unit x 25 units) Discount voucher $ 75 Total $2,575 Allocation of the $2,500 transaction price of Product A based on the incremental discount offered: Performance obligation Allocated transaction price Product A $2,427 ($2,500 / $2,575 x $2,500) Discount voucher $ 73 ($75 / $2,575 x $2,500) Total $2,500

12 New Developments Summary 12 The $2,427 allocated to Product A is recognized as revenue when control of Product A transfers to the customer. The $73 allocated to the discount voucher is recognized as revenue when the customer purchases the additional products or the offer expires. Any difference in the actual future purchase activity from the estimated amount does not impact the original allocation. Revenue on future discounted products is recognized as control of the products transfers to the customer. Step three: Determine the transaction price Under ASC 606, transaction price is defined as the amount of consideration an entity expects to be entitled to in exchange for the goods or services promised under a contract, excluding any amounts collected on behalf of third parties (for example, sales taxes). The transaction price may include fixed amounts, variable amounts, or both. An entity should consider the effects of all the following factors in determining the transaction price: Variable consideration Significant financing components Noncash consideration Consideration payable to the customer Variable consideration The amount of consideration received under a contract might vary due to discounts, rebates, refunds, credits, price concessions, performance bonuses, penalties, and similar items. The variable consideration guidance in ASC 606 also applies if the entity expects to offer a price concession or if the goods are sold with a right of return. Examples of arrangements with variable consideration that are typical in the life sciences industry include licensing arrangements with milestone payments, sales- and usage-based royalties, and product sales contracts that include rights of return, volume rebates, or other incentives. If a contract includes a variable amount, an entity is required to estimate the transaction price. To estimate the variable consideration in a contract, an entity determines either the expected value or the most likely amount of consideration to be received, depending on which method better predicts the amount to which the entity will be entitled. The expected value method might be appropriate in situations where the variable outcome is a range of outcomes and an entity has experience with a large number of similar contracts that provide a reasonable basis to predict future outcomes. The most likely amount method might be appropriate in situations where a contract has only two possible outcomes rather than a range of possible outcomes (for example, a bonus for early delivery that would be either fully received or not received at all). ASC 606 requires an entity to use the same method to estimate the variable consideration throughout the life of a contract. Constraint on variable consideration If the amount of consideration from a customer contract is variable, an entity must evaluate whether the variable consideration should be constrained. The objective of the constraint is for an entity to recognize

13 New Developments Summary 13 revenue only to the extent it is probable that a significant reversal in cumulative revenue recognized on the contract will not occur when the uncertainty is resolved. To meet the objective, an entity should assess whether it is probable that changes in the entity s estimate of variable consideration will not result in a significant downward adjustment of the cumulative amount of revenue recognized on the contract. In making this assessment, an entity should consider all of the facts and circumstances associated with both the likelihood and the magnitude of the reversal if that uncertain event were to occur or fail to occur. The following indicators might signify that including an estimate of variable consideration in the transaction price could result in a significant revenue reversal: The amount of consideration is highly susceptible to factors outside the entity s influence, such as market volatility, third-party actions, weather, and obsolescence risk. The uncertainty is not expected to be resolved for a long time. The entity s experience with similar contracts is limited or its experience has limited predictive value. The entity has a practice of offering a broad range of price concessions or changing the payment terms in similar circumstances. There are a large number and wide range of possible consideration amounts in the contract. An entity should update its estimate of variable consideration, including the application of the constraint, at the end of each reporting period to reflect changes in facts and circumstances. For example, if an entity previously determined that the transaction price should include $100 of variable consideration but now believes the variable amount is $200, this revision to the overall transaction price is subject to the constraint discussed above. In other words, the entity s assertion in reaching a conclusion to increase the transaction price to $200 would be that it is probable that a subsequent change in the estimate of variable consideration will not result in a significant revenue reversal. The new standard may also create more complexity and require judgment when estimating revenue at contract inception for amounts that are due from a customer as a product progresses through various development stages, such as milestone payments awarded on an all-or-none basis on successfully passing a research phase. High failure rates of product development projects may make it difficult to evaluate the probability of success of an individual project. Pharmaceutical, biotechnology, and certain other medical technology companies may sell products with a right of return. The sales with a related right of return are recognized as revenue for products only if an entity concludes that it is probable there is no risk of significant revenue reversal in future periods, as illustrated in the example below. We believe that rights of return will be accounted for similarly to current guidance under ASC 605. While most pharmaceutical companies typically destroy returned inventory, companies sometimes expect to resell the returned inventory. Under the new standard, the balance sheet in this case is grossed up to include the refund obligation and the asset for the right to the returned goods. The asset should be measured based on the former carrying amount of the products, less any expected costs to recover the product. The asset also needs to be assessed for impairment separately from inventory if indicators of impairment exist.

14 New Developments Summary 14 Rebates Examples: Variable consideration Under the terms of a contract with a customer, a medical device company provides a volume rebate to the customer after cumulative units purchased in a calendar-year exceed certain thresholds, as shown below. Each unit has a base price of $100. The rebate is retroactively applied to the beginning of each calendar year. Units Per unit rebate Likelihood of rebate percentage 0 100,000 0% 20% 101, ,000 5% 50% 201, % 30% To estimate the amount of variable consideration, one of the following two methods should be used, depending on which method the entity expects will better predict the amount of consideration to which it will be entitled: The expected value method: 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 transactions with similar characteristics. This estimate results in a rebate of approximately 5.5% [(0% x 20%) + (50% x 50%) + (10% x 30%)]. The most likely amount method: 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 will typically be considered the best estimate of the amount of variable consideration if the contract has two possible outcomes (for example, an entity either achieves or does not achieve a threshold). Application of this approach results in an estimated rebate of 5%. The approach used is a matter of judgment and should be based on which method the company believes provides a more precise, predictive measurement. Since the situation in this fact pattern has more than two outcomes, the company determined that the best estimate would be the rebate percentage computed under the expected value method. The new revenue standard does not require the use of the expected value approach if there are more than two outcomes, but if more potential outcomes exist, the expected value method would more likely be used. As an additional consideration, the company includes the variable consideration in the transaction price only if it is probable that doing so will not result in a significant reversal of revenue. If the company concludes that the revenue constraint applies to the total variable consideration, it would then consider whether there is a minimum amount for which it is probable that a significant reversal will not occur when the uncertainty is resolved. The minimum amount, if any, should be included in the transaction price. In the above example, we believe that because the rebate reduces revenue, the variable consideration under the contract is the incremental consideration in excess of $90 per unit (the per unit price net of the maximum discount of 10%). The revenue constraint would be applied to

15 New Developments Summary 15 the additional variable consideration related to the difference between a 10% discount and the estimated discount calculated using the expected value method. This assessment should be made each reporting period, with adjustments to prior estimates recognized as a component of revenue recognized in the current reporting period. Right of return A medical device company enters into an agreement to sell 100 products to a customer for $100 each, for a total of $10,000 in cash consideration. Cash is received when control of a product transfers. The company allows the customer to return any unused products within 60 days and to receive a full refund. The company s cost of each product is $60. Due to the return policy, the consideration received from the customer is variable. The company uses the expected value method to estimate the variable consideration because it believes this method provides a better predictive measurement of the returns. The company estimates that 10 of the products sold will be returned and, after evaluating the constraint factors in ASC , determines it is probable that a significant revenue reversal will not occur on the remaining 90 products based upon historical results. Therefore, the company includes $9,000 in the transaction price. The company also estimates that the costs of recovering the returned products is immaterial and that they can be resold at a profit. Upon transferring control of the 100 products to the customer, the company does not recognize revenue for the 10 products that it expects to be returned and records the following journal entries, assuming that a cash payment was received at the time when control of the products was transferred: Entry 1: To recognize revenue and refund liability based on product sold Dr. Cash $10,000 ($100 x 100 products transferred) Cr. Revenue $9,000 ($100 x 90 products not expected to be returned) Cr. Refund liability $1,000 ($100 refund x 10 products expected to be returned) Entry 2: To record cost of sales and return asset based on product sold Dr. Cost of sales $5,400 ($60 x 90 products not expected to be returned) Dr. Asset for product to be returned $ 600* Cr. Inventory $6,000 ($60 x 100 products) * $60 x 10 products for its right to recover products from customers on settling the refund liability. Entry to record when product is returned: Dr. Inventory ($60 per unit) Dr. Refund liability ($100 per unit) Cr. Asset for product to be returned Cr. Cash ($60 per unit) ($100 per unit)

16 New Developments Summary 16 If more products are returned than originally estimated and accrued, the excess would be recorded as a reduction in revenue and an increase in inventory, assuming the returned products can be resold. Assume that only 6 of the products are actually returned, as compared to the original estimate of 10 returns. The return period coincides with the end of the reporting period in which the sales occurred. When the return period lapses, the entry to recognize the actual returns would be as follows: Dr. Refund liability $400 ($100 x 4 products not returned) Dr. Cost of sales $240 ($60 x 4 products not returned) Cr. Revenue Cr. Asset for product to be returned $400 ($100 x 4 products not returned) $240 ($60 x 4 products not returned) Milestone payments A medical technology company enters into a contract with Company A to perform R&D services. The consideration under the contract includes two milestone payments. The milestones relate to (1) completing the enrollment and testing of patients in clinical trials and (2) obtaining regulatory approval. Upon completion of each milestone, the company will receive a predetermined amount of consideration from Company A. To determine if these milestone payments should be included in the transaction price at the inception of the contract, the company must determine if it is probable that a significant reversal of revenue recognized will not occur when the uncertainty associated with each milestone is subsequently resolved. Based upon its history of successfully enrolling and testing patients in past clinical trials, the company has determined that it is probable there will not be a significant reversal of revenue in relation to enrolling and testing patients and therefore includes this variable consideration in the transaction price at inception. The company determines that the milestone payment related to obtaining regulatory approval is highly susceptible due to factors outside of the company s control. Therefore, the company is unable to conclude that it is probable that a significant revenue reversal will not occur and at inception does not include consideration for the second milestone payment in the transaction price. Sales- and usage-based royalties on licenses of intellectual property Contracts for licenses of intellectual property often include sales- and usage-based royalties that represent variable consideration. ASC includes a specific requirement related to variable consideration in the form of sales- or usage-based royalties on licenses of intellectual property that is an exception to the normal accounting requirements for variable consideration. That requirement stipulates that an entity licensing its intellectual property under a contract that includes a sales- or usage-based royalty should include consideration from the sales- or usage-based royalty in the transaction price only when the later of the following events occurs: The subsequent sale or usage occurs (that is, the uncertainty is resolved).

17 New Developments Summary 17 The performance obligation to which the sales- or usage-based royalty is allocated has been satisfied. Companies also need to distinguish between a license of intellectual property and a sale of intellectual property. If the arrangement is evaluated as a license of intellectual property, the related sales-based royalties are recognized using the guidance in ASC as the sale or usage occurs. However, if the arrangement is evaluated as a sale of the license, the related sales-based royalties are evaluated and recognized in accordance with the variable consideration guidance in ASC and are recognized at the time of the transfer of control of the licensed product to the customer. Practical insight: Royalties Determining whether the license to intellectual property is subject to the sales- and usagebased royalty exception above requires judgment and depends on the particular facts and circumstances of each situation. Certain transactions may involve multiple performance obligations, such as a license to intellectual property as well as certain R&D services in exchange for consideration that includes a sales-based royalty. If the transaction is deemed to qualify as a single performance obligation, the exception above may not apply. Example 1 PharmaCo enters into a contract to license intellectual property to BioCo in exchange for a 5% sales-based royalty. Regardless of whether the promise to grant the license is a right to access or a right to use the intellectual property as discussed in Licensing arrangements below, PharmaCo applies the guidance in ASC and recognizes revenue when each sale related to the sales-based royalty occurs. This is because the consideration for the license of intellectual property is a sales-based royalty and PharmaCo has already transferred the license. Example 2 Assume the same facts in Example 1, except that PharmaCo sells rather than licenses the intellectual property to BioCo. PharmaCo will record revenue when control of the intellectual property is transferred to BioCo based on the amount of variable consideration estimated under the guidance in ASC , but only to the extent it is probable that a significant reversal in the amount of revenue will not occur once the uncertainty related to the royalty is subsequently resolved in accordance with ASC The estimated amount of the variable consideration should be reassessed each reporting period, with adjustments to prior estimates recognized as a component of revenue in each reporting period. Significant financing components In determining the transaction price, an entity must reflect the time value of money in its estimate of the transaction price if the agreed-upon timing of payments in the contract includes a significant financing component, whether explicit or implicit. The objective in adjusting the transaction price for the time value of money is to reflect an amount for the selling price as though the customer had paid cash for the goods or services when they were transferred. Either party may receive credit that is, the customer may pay before the entity performs its obligation (in essence, a customer loan to the entity) or it may pay after the entity performs its obligation (in essence, a loan by the entity to the customer). For example, medical device and pharmaceutical companies that sell products to a customer under extended payment terms need to evaluate whether a significant financing component is present in the contract.

18 New Developments Summary 18 To determine whether a financing component is significant, an entity must consider all relevant facts and circumstances, including, but not limited to, the following: The difference, if any, between the promised consideration and the cash price that would be paid if the customer had paid as the goods or services are delivered The combined effect of both The expected length of time between delivery of the goods or services and receipt of payment The prevailing market interest rates A contract may not have a significant financing component if any one of the following scenarios exists: Advance payments have been made, but the timing of the transfer of the good or service is at the customer s discretion. The consideration is variable based on factors outside the vendor s or customer s control (for example, a sales-based royalty). A difference between the promised consideration and the cash price relates to something other than financing, and the difference is proportional to the reason for the difference, such as protecting one of the parties from the other party s nonperformance (for example, a customary retainage of a certain percentage of all payments made until completion of a project). As a practical expedient, an entity can ignore the impact of the time value of money on a contract if it expects, at contract inception, that the period between the delivery of goods or services and the customer payment will be one year or less. To adjust the amount of consideration for a significant financing component, an entity should use the discount rate that would be reflected in a separate financing transaction between the entity and the customer at contract inception. That rate should reflect the credit risk of whichever party is receiving credit (for example, the customer s rate if payment is deferred and the vendor s rate if payment is made in advance). An entity presents the effects of financing separately from revenue as interest expense or interest income in the statement of comprehensive income. Noncash consideration Under ASC 606, if a customer promises consideration in a form other than cash, an entity should measure the noncash consideration at fair value in determining the transaction price. This includes arrangements in which the customer transfers control of the goods or services to the vendor to facilitate the vendor s fulfilment of a contract. For example, a pharmaceutical company might receive shares from a development-stage biotech company in exchange for license rights to technology needed to develop a product. In this case, the pharmaceutical company should recognize revenue based on the fair value of shares received. If an entity is unable to reasonably measure the fair value of noncash consideration, it should indirectly measure the consideration by referring to the stand-alone selling price of the goods or services promised under the contract. Consideration payable to a customer Consideration payable to a customer includes amounts that an entity pays or expects to pay to a customer in the form of cash or noncash items, including credit or other items that the customer can apply