Jalpa Sonchhatra, Director, Financial Accounting Advisory Services, EY India speaks on the strategies needed to ensure compliance with IndAS 115
The Ministry of Corporate Affairs (MCA) has notified Ind AS 115 – Revenue from Contracts with Customers with effect from 1 April 2018. The new standard will supersede virtually all revenue recognition requirements under Ind AS that apply to life sciences entities today.
The key issues for life sciences entities include determining how the new standard applies to: Collaboration arrangements, arrangements with variable consideration and licenses of intellectual property. Further, application of Ind AS 115 will require life sciences entities to use significant judgement and make more estimates than they do under Ind AS 18. Companies also need to recalibrate their internal control, policies and systems for financial reporting to ensure compliance with new requirements.
Life sciences entities frequently enter into complex collaboration agreements with other parties. In certain arrangements, a counterparty may not be “a customer” of the entity, as defined in Ind AS 115. Instead, the counterparty may be a collaborator or partner that shares risks and benefits of developing a product to be marketed, for example, when two pharmaceutical (pharma) companies enter into a collaborative arrangement to develop a product candidate. In absence of additional application guidance, life sciences entities may find it challenging to determine whether their collaborative arrangements are within the scope of Ind AS 115.
Participation on a joint steering committee
Collaborative R&D arrangements often include provisions requiring constitution of, and participation in, a joint steering committee (JSC) to make decisions about the collaborative activities. For example, a biotechnology entity that has a revenue contract with
a pharma entity could be required to provide its expertise through participation on a JSC in addition to licensing a product candidate and performing R&D services. If participation in the JSC is determined to be a promised service in the arrangement, resultant revenue recognition implications will follow accordingly.
Customer options to acquire additional goods or services
Life sciences contracts mayinclude a right for the customer to purchase additional goods or services at a discount. For example, if a life science entity sells the intellectual property for a specific drug to another entity. At the same time, it also grants the counterparty an option to sub-contract the manufacture of the drug back to the entity at a fixed price, which is lower than the market price. If this option represents a material right for the customer, the seller will need to allocate a portion of the transaction price to the option and recognise revenue when control of the goods or services
underlying the option is transferred to the customer, or when the option expires. In this particular scenario, the entity selling the license will need to evaluate whether some of the revenue receivable at the time of granting the license should be deferred and recognised at a later date. Some items that are considered marketing
incentives or incidental goods or services under legacy Ind AS will have to be evaluated under Ind AS 115 to determine whether they represent promised goods or services in the contract.
Milestone and other variable payments
Many life sciences entities enter into long-term contracts which may include significant variable payment, such as rebates, incentives, performance bonuses, contingencies or concessions. For example, the transaction price may vary depending on the price at which the product is sold by a reseller or distributor or on achieving certain milestones. Also, variable consideration can result from explicit contract terms or can be implied by a life sciences entity’s past business practices or intentions under a contract. Ind AS 115 requires an entity to estimate variable consideration using the method (i.e., most likely amount or expected value) that best predicts the amount to which the entity will be entitled. Life science entities need to consider all information (e.g., historical, current and forecast) that is reasonably available to them while estimating such variable consideration.
Rights of return
Life sciences entities often provide customers with a right to return a transferred product for a specified period of time after sale. A right of return creates variability in the transaction price that a life sciences entity needs to estimate. A life sciences entity will recognize revenue based on the amount to which it expects to be entitled through to the end of the return period. Therefore, it will not be able to recognise the portion of the revenue till the end of the return period resulting into refund liability till that point. The standard also requires a return asset to be recognised at the time of the initial sale, if an entity expects to receive the returned product in saleable or repairable condition.
Separately presenting the right of return asset and refund liability on the balance sheet will be a change in practice for some medical technology entities. For other entities in the life sciences industry, returns frequently have no value because of product expiration or requirements to destroy returned inventory.
Licenses of IP
Life sciences entities commonly enter into arrangements with customers that include licenses of IP, such as licenses for product candidates or patented drug formulas. Ind AS 115 distinguishes between licenses that represent the transfer of a right to use an entity’s intellectual property and licenses that represent the provision of access, over a period of time, to an entity’s intellectual property and specifies criteria to determine which type of license is being sold. Revenue for the former will typically be recognised at a point in time, revenue for the latter will typically be recognised over the period of access.
Ind AS 115 also provides application guidance on the recognition of revenue for sales-based or usage-based royalties received in exchange for licenses of IP and requires that royalties are recognised at the later of when: (1) The subsequent sale or usage occurs; or (2) The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated is satisfied (in whole or in part).
A life sciences entity will have to analyse the facts and circumstances of each contract (or type of contract) in order to determine when and how to apply the application guidance to licenses of IP and may need to use more judgement than it did under legacy Ind AS. The units of account and timing of revenue recognition may also change.
Ind AS 115 requires either a full retrospective adoption in which the standard is applied to all the periods presented or a modified retrospective adoption. Certain practical expedients are available under both methods. Irrespective of transition choice applied, all open contracts which are outstanding as of 31 March 2018 need to be revisited for its appropriate accounting and disclosures in relation to timing and the amount of revenue to be recorded through the financial statements. All transition related changes will be recorded through opening retained earnings.
In addition to the key changes discussed above, Ind AS 115 introduces detailed guidance in many areas regarding the reporting of revenue and entities will need to ensure that they have considered all of these when assessing the extent to which their accounting policy for revenue may need to be amended. Life sciences companies should perform an assessment of how they will be affected as soon as possible so they can determine how to prepare to implement the new standard for the current fiscal year. While the effect on entities will vary, some may face significant changes in revenue recognition.