Life Sciences Articles
Revenue Recognition for Life Sciences Companies
By Richard Hirschen, CPA
Gray, Gray & Gray, LLP
You can easily recognize revenue, right? Who could mistake a pile of cash or a big check? But recognizing revenue in accordance with Generally Accepted Accounting Principles (GAAP) takes on an entirely different meaning, one that is critical in the life cycle of a growing business. Particularly when that business is in the life sciences industry.
Revenue is a leading indicator for banks and investors as well as the public. For many early stage companies it is used to demonstrate traction and the existence of a market for the product or service. Since revenue is such an important figure, it is vital for a company to have policies in place that outline the specific conditions that must be met in order for the company to accept (or "recognize") revenue at the proper point in time.
This article is intended to discuss the issues relating to revenue recognition for financial purposes only. The tax treatment of revenue may be entirely different from financial statement treatment and should be considered before entering into any long-term agreements.
According to SAB 101, revenue should be recognized when payment from the customer is realized and the earnings process is complete. The payment from the customer is considered realized - or realizable - when the buyer has a contractual right to pay a specific amount for a specific product or service. Stated another way, the payment is considered realized when the seller receives cash or a claim to cash. In the event of "realizable" revenue, it should not be recognized unless the ability to actually collect is reasonably assured. Determining when income from research funding should be recorded is contingent upon the stage the research project is currently at. As a result it is important to read these agreements and determine, or even better, negotiate the contract milestones with the company's revenue recognition policy firmly in mind. As far as state, local and governmental grants are concerned care should be taken again to understand the terms under which the grant is based in order to accurately reflect the related revenue.
Determining when the earnings process is complete is a bit more complicated. The earnings process is determined to be complete when the seller has completed substantially all required steps to be entitled to the benefits represented by the revenue. The type of sale and the agreement between the buyer and seller will determine when the earnings process has been completed.
Generally the earnings process is not complete until delivery has occurred or service has been rendered. Delivery is deemed to have taken place when the customer takes title to the product and when the risks and rewards of ownership have passed to the buyer. However, it is short sighted to state that revenue can be realized when the product is delivered. Other items to consider include shipping terms, additional obligations of the seller after the delivery has taken place, and whether or not there is a right of return.
The most common shipping terms are FOB (freight on board) shipping point or FOB destination. In other words, the delivery is considered complete when the shipment is either placed on a truck by the seller, or arrives at the buyer's location. If there are no other items in the contract that would preclude revenue recognition, it would be appropriate to recognize revenue at time of shipment, according to the shipping terms.
If a sales contract states that delivery is required along with installation of the item being shipped, revenue should not be recognized until the seller has substantially completed or fulfilled the terms specified in the arrangement. If the terms state that item must be installed and functioning, then revenue should not be recognized until the item is installed and functioning.
Even if title or the risks and rewards of ownership have passed to the buyer, it still may not be appropriate to recognize revenue. Another possibility to consider is whether the buyer has a right to return the product. This requires careful consideration.
Aside from comestibles and services, most items sold come with the understanding that they can be returned. When this is the case, you need to look at the historical rate of return and determine if these returns are material in relation to the amount of sales. Often they are not and revenue recognition would be considered appropriate at the time of sale. In other situations the revenue should be deferred until the right of return period has expired.
Other instances where deferral of revenue recognition is appropriate include if the buyer does not pay the seller at the time of the sale and the buyer is not obligated to pay the seller at a specified date, if payment by the buyer is contingent on the buyer reselling the product, if the buyer's obligation to the seller would be changed in the event of theft or destruction of the product, or if the seller has significant future obligations to the buyer.
Revenue for a service contract or similar situation should be recognized evenly over the period the seller is to provide the service, regardless of when the payment is received. Even when the payment is a non-refundable up front fee (unless the up-front fee is in exchange for products delivered or services performed that represent the culmination of the earnings process) the revenue should be deferred and recognized over the entire period in which the fees are earned.
In the life sciences industry agreements are often made that include various payments such as non-refundable signing fees, funding for research and development, milestone payments and other special circumstances. These agreements need to be thoroughly analyzed to determine if each of the payments should be treated as separate elements.
To be considered separate elements, the product or service in question must represent a separate earnings process. Revenue recognition would then be determined for each element separately.
The presumably simple process of knowing when to recognize revenue can obviously become very complex in the life sciences industry. Having a system and policies in place to choose the correct point at which to recognize revenue plays an important role in the overall financial strategy of a growing life sciences company.
Richard Hirschen, CPA is an accountant with Gray, Gray & Gray, LLP, Certified Public Accountants, Westwood, MA. Gray, Gray & Gray serves the tax and accounting needs of businesses in the life sciences industry. Mr. Hirschen can be reached at (781) 407-0300, or via e-mail to: rhirschen@gggcpas.com.