Issue: Decide how to account for the funding of the R&D and royalty payments. Identify the authoritative literature applicable to this funding arrangement and discuss the appropriate accounting for the agreement in accordance with that guidance.
Pharmagen is a pharmaceutical company
Company XYZ is an unrelated third-party private equity investor with no prior relationship or business operations related to Pharmagen Pharmagen and Company XYZ have entered into a funding agreement The agreement states Pharmagen will receive up to $500 million funding for R&D costs as they are incurred solely for the research efforts of a potential new drug “X” Any funding received is non-refundable and Pharmagen is not obligated to successfully complete the development of X Pharmagen is operating under a “best efforts” arrangement Pharmagen estimates the R&D costs will total $1 billion and will take 3 years to complete Company XYZ receives royalties associated with future revenues of X and future royalties associated with an existing commercialized drug for a defined period of time but Pharmagen retains all intellectual property rights Position: I believe it is obvious that this agreement is applicable to the treatment of ASC 730-20 as a research and development arrangement based on ASC 730-20-20’s definitions. It now becomes important to determine the nature of the obligation and distinguish if the funding is a liability to repay the PEI or an obligation to perform contractual services.
According to ASC 730-20-25-4, “To conclude that a liability does not exist, the transfer of the financial risk involved with research and development from the entity to the other parties must be substantive and genuine.” You can then look to ASC 730-20-25-6 for the four conditions that will lead to the presumption that the entity will repay the other party. If any of these conditions are met, the funding would create a liability. The fact that Pharmagen has no indent to repay the PEI, they would not suffer a severe economic penalty if they failed to repay any of the funds, they have no significant related party relationship, and Pharmagen is still quite a ways from completing the R&D it would appear that there is no liability recorded (ASC 730-20-25-6). Unfortunately if you read ASC 730-20-25-8 describing what constitutes an obligation to perform contractual services, it “depends solely on the results of the research and development having future economic benefit.” Since part of the agreement entails payment of royalties from an existing commercialized drug, Pharmagen is not transferring all the financial risk because the repayment is not exclusively reliant on the development of the new drug X.
This is why I believe it is the best practice to record the funding as a liability and according to ASC 730-20-25-7, “charge the research and development costs to expense as incurred.” Other Solutions: Another option is to look at ASC 470-10-25 for guidance on an accounting approach. When using this method the funding is either considered debt or deferred income. This standard applies when, “An entity receives cash from an investor and agrees to pay to the investor for a defined period a specified percentage or amount of the revenue.” To distinguish is the funding is to be considered debt or deferred income ASC 470-10-25-2 provides six criteria in which if any are met causes the funding to be classified as debt.
One of the criteria is that Pharmagen will have, “significant continuing involvement in the generation of the cash flows due the investor” which is true because Pharmagen will retain the intellectual property rights. It then also becomes important to be aware of ASC 470-10-35-3 where the debt will be amortized under the interest method. Discussion: I picked the use ASC 730-20 because it applies to this case’s circumstances better than ASC 470. Because ASC 470-10-25 deals with sales of future revenue the completion of the drug must be probable, but according to the case, this is not the circumstances yet. If there was less uncertainty around the development of this drug, this would be the better standard to follow when accounting for these funds.
If it were possible to split the funding up and account for a portion of it under ASC 730-20 and the rest under ASC 470-10. Any amount allocated to repayment from the already commercialized drug could be recognized as deferred income under ASC 470-10. The remaining the remaining funding for the new drug X could be recorded as an obligation to perform contractual services under ASC 730-20. Unfortunately because the case does not provide a manner to allocate the funding this is not the best option.