Revenue Recognition: 8 Key Questions for Life Sciences Companies

Revenue Recognition: 8 Key Questions for Life Sciences Companies

By Maureen Earley

Revenue recognition (aka rev rec) isn’t a hot topic at most life sciences companies, but recent and upcoming rule changes and the marvelous complexity of life sciences revenue arrangements make it essential that executives at least know the right questions to ask for their field. That’s true even if you don’t yet have revenue—knowing what issues you’ll have to deal with and laying the groundwork now can save significant time and money later. 

Biotech Companies

Early in their lifecycles, biotech companies frequently enter into collaboration agreements. These agreements are usually structured with an upfront payment by the partner, then one or more additional payments based on meeting specified milestones in the development process. Key rev rec questions:

1. Can the upfront payment be recognized immediately or must it be spread over the term of the collaboration? 
2. Are the milestones substantive enough that each payment can be recognized as revenue when the milestone is met, or is some other method more appropriate? 

Later in their lives, after developing a successful product, biotechs may also have to deal with licensing and royalty revenue.

Pharmaceutical Companies

The majority of pharmas’ revenue is derived from manufacturing and selling drugs, either developed in house or in collaboration with biotechs. Revenue recognition should be easy—manufacture the drug, ship it to a customer, recognize revenue—right? Not quite. 

Most pharmas have complicated distribution channels. After manufacturing, the drug may be shipped to a distributor, which may take title to the shipment or may simply warehouse it until it is shipped to a wholesaler. Wholesalers then sell to pharmacies, which in turn sell and dispense the drug to patients. Key rev rec questions:

1. Where in that chain does title to the drug pass from your company to a third party? 
2. Can you estimate returns? Virtually all pharmas allow drugs past or even near their expiration date to be returned. If you cannot reliably estimate the amount of returns, as required by accounting rules, then you can recognize revenue only when the return right has expired, usually when the drug has been dispensed to a patient. 
3. How can you determine what has been dispensed to patients? You may be in luck. Because of the pervasiveness of this issue, an ancillary industry has arisen to report drug inventories within the distribution channel, including amounts dispensed to patients.

Instrument and Device Companies 

Companies that sell instruments and devices, such as surgical tools or equipment used in medical labs, face completely different rev rec issues, including rule changes. In many cases, instruments and devices are a combination of hardware and software, which used to mean that revenue had to be recognized using the more restrictive software rev rec rules. Beginning in 2011, products including hardware and software that work together to provide the essential functionality of the device are exempted from the software rules. 

Instruments and devices are also sometimes sold with services such as installation, training, and ongoing maintenance. Under the old rules, a company might have had to recognize all revenue on a straight-line basis over the total service period if it did not have vendor-specific objective evidence (VSOE) of the fair value of one or more undelivered services. Effective in 2011, companies must estimate selling prices for each contract element and allocate the total arrangement value to those elements based on their relative fair values. For most companies, this will provide a better answer—but estimating selling prices comes with its own challenges. Key questions:

1. Do you have VSOE of fair value? (VSOE is the price charged for a deliverable when it is sold separately.) 
2. If not, do you have third-party evidence, or TPE? (TPE is the price of any third-party company’s interchangeable products or services sold on a stand-alone basis to similar customers.)
3. What’s your best estimated selling price? If you have neither VSOE nor TPE, you must use your best estimate of the selling price. (This is a company-specific accounting analysis that re¬quires input from various departments—sales, marketing, R&D, and possibly others—and plenty of documentation.) 

Pre-Revenue Companies 

Rev rec may not be at the forefront for companies that don’t yet have revenue, but the questions above should be simmering on a back burner. That way, you’ll be able to plan ahead and address your issues in the most advantageous manner possible.

About Maureen Earley: A senior RoseRyan consultant with more than 25 years’ experience, Maureen Earley serves as a technical resource for the RoseRyan team. Revenue recognition is one of her specialities. To find out more about rev rec issues and how RoseRyan can help you figure them out, go to: http://www.roseryan.com/services/rev-rec.php.