Financial Accounting Advisory Services Implementing the new revenue recognition standard Life sciences September 2015
Contents Implementing the new revenue recognition standard for life sciences Overview 4 The challenge ahead 7 How EY can help you 24 About EY 34 Contacts 37 Page 2
Implementing the new revenue recognition standard Page 3
Overview Why is the change significant? Construction Contracts (IAS 11) Customer Loyalty Programs (IFRIC 13) Agreements for the Construction of Real Estate (IFRIC 15) Revenue Barter Transaction Involving Advertising Services (SIC 31) Revenue (IAS 18) Transfer of Assets From Customers (IFRIC 18) Adoption of IFRS 15 Requires evaluation of the policies, processes and systems by which revenue is recognised and disclosed Utilises more principles than prescriptive rules and may require more estimates and greater judgement Provides more detailed requirements and application guidance than current IFRS Potential changes: Changes in the number of performance obligations (identify new POs, track information, and allocate revenue to them) Timing of revenue recognition Disconnect between billing and revenue recognition, in some cases Lost revenue upon transition Expanded disclosures Page 4
Overview Summary of IFRS 15 Revenue recognition model Core principle: recognise revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services Step 1 Identify the contract(s) with the customer Step 2 Identify the performance obligations in the contract Step 3 Determine the transaction price Step 4 Allocate the transaction price to the performance obligations in the contract Step 5 Recognise revenue when (or as) each performance obligation is satisfied Page 5
Overview You have a choice between two transition methods Reporting under IAS 18/11 2016 and prior 2017 2018 2019 onwards Before adoption Reporting Legacy GAAP Legacy GAAP Footnotes Disclose anticipated impact of IFRS 15 Full retrospective After adoption Reporting Footnotes Modified retrospective Legacy GAAP Cumulative catch-up adjustment New GAAP New GAAP New GAAP IAS 8 Accounting Policies, Changes in Accounting Estimates Enhanced Enhanced After adoption Reporting Legacy GAAP Legacy GAAP New GAAP New GAAP Footnotes Cumulative catch-up adjustment There is potential for a one-time impact on revenue under either method This may impact your decision on how to transition to IFRS 15 Note: The IASB has proposed a deferral of the effective date to 1 January 2018 Legacy GAAP Enhanced Enhanced Page 6
The challenge ahead More than an accounting change Revenue is embedded into most dayto-day business processes for life science companies. Changing the methodology of recognition has wide ranging business impacts. From processes and controls, to tax accounting, numerous areas may be affected. This is an opportunity to both streamline and automate those processes that have evolved over time. Business operations Processes and systems Training and communication Control environment Revenue recognition impacts Tax planning Sector issues Project management Management information Employee incentives Investor relations Page 7
The challenge ahead What makes this complex? Contracts Identifying performance obligations Transaction price Allocation Recognition timing Identifying all terms of the contract Identifying goods and services Base transaction price Determining standalone selling prices Transfer of control: point in time or over time Combining contracts Identifying performance obligations Variable consideration, including bonuses, returns, rebates Allocating attributable variable consideration Repurchase provisions Contract modifications Service-type warranties Constraint Allocating attributable discount Bill-and-hold transactions Established business practices Options granting a material right Significant financing components Consignment arrangements Identifying the customer (e.g., principal vs. agent) Non-cash consideration Customer acceptance Determining legal enforceability Payments to customers Licences Changes in transaction price Measuring progress and transferring control Page 8
The challenge ahead Drivers of complexity Less complex More complex Shorter revenue cycle Long-term contracts Single line of business Domestic operations only Highly centralised Well-controlled process currently provides revenue estimates No change to existing performance obligations Multiple, diverse businesses Global operations Decentralised Limited estimates required by current revenue recognition process Changes in the number of performance obligations under new model Multiple, disparate IT systems One global ERP Strong organisational change management Organisation struggles to implement change Page 9
The challenge ahead Key questions: what does it mean for you? Financial impacts What revenue streams and unique contracts exist? What is the magnitude of financial impact to key performance indicators (KPIs) such as revenue growth, core versus non-core performance, gross margin and EBITDA? Transition impacts How long will the transition take, and when should you start? What resources and budget are required? What other internal projects overlap? Does your organisation have a preferred transition method? Organisational and system impacts Will the requirements of IFRS 15 impact the structure of your contracts with customers? Will you need to reconfigure your enterprise resource planning (ERP) systems to capture all the necessary financial and operational information, including the data needed for transition? Do you have the ability to accurately capture the contractual and other required data points? Will the standard create new book/tax differences and/or methods changes? How do your company s implementation plans benchmark against your competitors? How and when will you communicate to internal and external stakeholders? Page 10
The challenge ahead Example of identified challenges for the life sciences sector Step 1: identify the contract 1 Step 2: identify the POs 2 Is this a contract with a customer? Products sale contract with or without volume commitment Contracts with oral or implied terms Services contract or collaboration agreement? Contract combinations Collaboration agreements: in scope of IFRS 15? Products sale contracts including services (medical devices, product/sale support) Co-development and co-marketing contracts Transportation and insurance as separate POs? Principal vs.agent analysis Patients support costs Costs and other issues Step 3: determine the transaction price 3 Contract costs: costs to obtain the contract, Life sciences Variable consideration (rebates, milestones, performance bonuses, right of returns policy) and the constraint Sales to distributors/resellers and consignment stock Financing component (e.g., long-term R&D-contracts) Consideration paid to customers Will your systems and procedures enable you to identify all variable consideration at contract inception? Step 5: Recognise revenue 5 Step 4: allocate transaction price to POs 4 Transfer of control (incoterms) Licence agreements (right to access vs.right to use) Sales-based royalties Milestones payments Stand-alone selling price: Stand-alone selling prices may not always be clear Need to apply appropriate estimation method or residual method (if applicable) Page 11
The challenge ahead Key questions for the life science sector 1 Identify the contract(s) with the customer Pharma A primarily sells its products to wholesalers that, in turn, sell the product to retail pharmacies, hospitals and other health care systems. Pharma A has contracts in place with the wholesalers. Pharma A also has various contracts in place with the ultimate payers of its products, including managed care organisations, hospitals and health care systems. Given the complexity of identifying the customer in life sciences contracts, is the entity clear about the customer s identity in each of its contractual arrangements? Are there any contracts in which oral or implied terms have been agreed on (which may need to be accounted for under the new standard)? Is collection probable for all arrangements (which under the new standard is one of the criteria for a contract to exist)? Have systems and processes been developed across the various markets to ensure that all contracts in scope of the standard are being identified? Page 12
The challenge ahead Key questions for the life science sector 1 Identify the contract(s) with the customer: collaborations Many entities in the life sciences sector enter into complex arrangements aimed at developing and commercialising products. For example, it is common practice for a biotechnology entity and a pharmaceutical entity to enter into a collaboration to develop a drug candidate for commercialisation. To determine whether or not this type of arrangement, or portions of this arrangement, is in scope of IFRS 15 will require judgement by management. Are the entities contracting to work together to develop a candidate such that the risks and benefits are shared? Is the biotechnology company selling or licensing the compound to the pharmaceutical company and also providing R&D services? Is the collaboration partner a customer for some or all aspects of the contract? Can contracts be considered partially within the scope of IFRS 15 and partially outside the scope? Page 13
The challenge ahead Key questions for the life science sector 2 Identify separate performance obligations There may be complexity when considering how to account for arrangements that include a license and other services. For example, a typical transaction might involve Pharma A entering into a single contract with Pharma B that includes an out-licence of an early stage drug compound for development and commercialisation to Pharma B,as well as providing R&D services and manufacturing services to Pharma B. Licence Step 1: capable of being distinct Can customer benefit from the licence in conjunction with other readily available resources? Can Pharma B provide R&D services on its own or purchase from multiple other providers? If yes, licence is capable of being distinct. Move to Step 2. Step 2: distinct in the context of the contract The entity would have to consider whether the licence and R&D services are highly interrelated by considering such questions as: - Is integration or customizing required? - Is the licence distinct on its own? R&D and manufacturing services Can R&D activities and manufacturing services be provided by multiple other providers? Also, can Pharma B benefit from the services in conjunction with a readily available resource (i.e., the licence that has already been provided)? If yes, the R&D services are capable of being distinct. Move to Step 2. The entity would have to consider whether the licence, R&D services and manufacturing services are highly interrelated by considering such questions as: - Is integration or customizing required? - Are the R&D services and manufacturing services distinct on their own? Page 14
The challenge ahead Key questions for the life science sector 3 Determine the transaction price IFRS 15 requires an entity to estimate variable consideration using either the most likely amount method or the expected value method, depending on which method best predicts the amount to which the entity will be entitled. Assuming the expected value approach is the technique that best predicts the amount the entity will receive for certain types of variable consideration, at what level should the expected value analysis be prepared? Expected value Sum of the probability-weighted amounts in a range of possible outcomes Most predictive when the transaction has a large number of possible outcomes Can be based on a limited number of discrete outcomes and probabilities Can a portfolio approach be used? If yes, at what level? Product? Therapeutic class? Other? Page 15
The challenge ahead Key questions for the life science sector 3 Probability at the payer (contract) level? Determine the transaction price: variable consideration Multiple outcomes at each payer (contract) level? Expected rebate value (23.7%) 40% Medicaid (23%) 50% Managed care (15%) 5% Cash (0%) 5% Returned product (100%) Managed care (15%) 20% MC org 1 (20%) 30% MC org 2 (12%) 40% MC org 3 (15%) 10% MC org 4 (14%) 100% Fee for service (2%) Page 16
The challenge ahead Key questions for the life science sector 3 Determine the transaction price: variable consideration outcomebased pricing Pharma A recently received regulatory approval to sell Drug A. Pharma A sells Drug A to a hospital network, and the hospital administers the drug to patients. The hospital is required to pay for Drug A upon shipment based upon a contracted price (30-day terms). The hospital is eligible for a 100% refund if, after 90 days, the patient has not had a positive response to the treatment using Drug A (based upon criteria defined in contract). How is the transaction price determined, and what factors may affect it? What is the history of performance of the medication in other territories or patient groups (if any)? Since for a newly launched product such history may not be available, can data of comparable drugs that are already sold in the market be used to derive estimates of the transaction price? What if there are tiered outcomes and associated payments included in the arrangement? Are there instances where revenue is currently deferred, because fees cannot be reliably measured or because there is a non-refundable floor price or minimum consideration as part of the arrangement, that will now be recognised subject to the constraint? For arrangements with variable consideration (likely to be most arrangements in the life sciences sector), has it been determined whether the most likely method or expected value method should be used? What systems are needed to capture the information necessary to calculate the expected value? What changes are necessary to existing processes, procedures, documentation and controls? Page 17
The challenge ahead Key questions for the life science sector 4 Allocate the transaction price exceptions for allocating variable consideration Variable consideration is required to be allocated to one PO if both of the following conditions are met: The contingent payment relates specifically to the entity s efforts to satisfy that PO The amount allocated entirely to that PO is consistent with the overall principle for allocating consideration If variable consideration does not meet the criteria above, it is allocated to all POs based upon the relative standalone selling price Page 18
The challenge ahead Key questions for the life science sector 5 Recognise revenue: POs are satisfied at a point in time A good or service is generally considered to be transferred when the customer obtains control The following are indicators of when control is transferred: The entity has a present right to payment for the good or service The customer has legal title to the asset The customer has physical possession The customer has the risks and rewards of ownership of the asset The entity has evidence of the customer s acceptance of the asset When does control transfer for product sales? Does the concept of risks and rewards of ownership go away? How is today s concept of synthetic FOB destination affected? Page 19
The challenge ahead Key questions for the life science sector 5 Recognise revenue licences Must first determine whether the licence is a distinct performance obligation in the arrangement If not distinct, account for consistent with the attributes of the combined unit of account For a distinct licence, assess the nature of the promise Assessment should not include activities that have been identified as a separate (i.e., distinct) performance obligation Dynamic license: Promise to provide access to the entity s intellectual property (recognise revenue over time) There is either an explicit requirement or an implicit understanding that the entity will undertake activities to maintain or enhance the intellectual property to which the licence relates. The licence exposes the customer to any changes to the intellectual property that arise as and when the entity undertakes those activities. Static license: Promise to transfer a right (recognise revenue as of a point in time) Page 20
The challenge ahead Key questions for the life science sector 5 Recognise revenue: reseller and distributor arrangements Under the new standard, life sciences entities that sell their products through distributors or resellers may recognise revenue earlier than under current rules. Today, some entities that use resellers wait until the product is sold to the endcustomer to recognise revenue, because they do not meet all of the criteria in the risk and rewards model in IAS 18 Revenue to recognise revenue on delivery to the reseller. Under IFRS 15, life sciences entities will need to first evaluate when control, rather than only the risks and rewards, of the product transfers to the customer. Are entities clear on which of their contracts would be accounted for as consignment arrangements under the new standard and which would not? Do entities have the necessary systems data and information to determine when to recognise consideration if a change in timing is required compared with current IFRS? How will entities determine if the constraint on variable consideration requires a reduction of the transaction price? Page 21
The challenge ahead Why start a diagnostic now? Various factors may influence your decision about when to start the implementation process Processes Revenue is embedded into almost every business process, system and control implementing the new revenue recognition standard may be a lengthy process Profits Changes in the amount and timing of revenue may result in changes to profits this may have tax implications KPIs KPIs, covenants and employee incentive plans are likely to be affected by revenue anticipating changes early can help you to mitigate risks Audit Involving your external audit team early on will smooth the transition process Industry What are other life sciences companies doing to tackle the changes? Page 22
The challenge ahead Why start a diagnostic now? Developing potential diagnostic activities now will help you to: Build an implementation team and governance protocols with appropriate organisational representation Identify key constituencies and prioritise their preliminary requirements, benefits and constraints Identify relevant revenue streams and unique contracts (many of which may be owned by a local market) Understand high-level financial and existing in-flight project impacts (e.g., new IT system roll-outs) Make an informed decision on which transition method is preferred and attainable Prepare a detailed planning budget to understand the level of human and financial resources required Answer stakeholder questions regarding changes and impact Participate in life sciences industry and geographical working groups to help influence developing practices Page 23
How EY can help you Implementation methodology 1 2 3 4 5 Phase Diagnostic Design and planning Solution development Implementation Postimplementation A five-phase model for entities implementing this accounting change is recommended. There are also four dimensions to consider: accounting and reporting, tax, business processes and systems, and change management, communication and training. For each phase, depending on the nature and magnitude of change required, we can bring in knowledgeable and experienced professionals from across EY s service lines. EY s (FAAS) core team will lead the project, helping to deliver a smooth implementation. Page 24
How EY can help you Phase 1: diagnostic 1 2 3 4 5 Phase Diagnostic Design and planning Solution development Implementation Postimplementation EY can support and advise you to: Understand the requirements of the new standard Determine the preliminary impact on the entity Identify significant revenue streams and analyse representative contracts under the new standard to understand the impacts on all work streams Accounting and reporting Tax Revenue: measurement and timing Disclosures Business processes and systems Change management Page 25
How EY can help you Phase 1: diagnostic 1 2 3 4 5 Phase Diagnostic Design and planning Solution development Implementation Postimplementation Outputs of the diagnostic phase Accounting and reporting work stream Accounting training materials Summary of revenue streams Accounting position papers for representative contracts Selection of transition method All work streams Report summarising preliminary assessment of affected areas and areas of focus to be built into the project plan Page 26
How EY can help you Phase 2: design and planning 1 2 3 4 5 Phase Diagnostic Design and planning Solution development Implementation Postimplementation EY can support and advise you as you: Analyse outputs from the diagnostic phase Develop a detailed project plan based on the transition method selected to address the issues identified in the diagnostic for each work stream Monitor the project plan on an ongoing basis and continually update based on new feedback Outputs of the design and planning phase All work streams Project management and budget Detailed project plan Communication and training strategy Page 27
How EY can help you Phase 3: solution development 1 2 3 4 5 Phase Diagnostic Design and planning Solution development Implementation Postimplementation EY can support and advise you to: Develop action items identified in the project plan Examples of outputs from each work stream: Accounting and reporting: draft accounting policies in line with the new standard, accounting position papers analysing additional contracts to determine the impact, an approach for calculating the cumulative catch-up adjustments (if any), draft disclosures to comply with new requirements Tax: new and updated tax basis, changes in tax policies, redesigned tax reporting package, approach for calculating tax impact difference Business processes and systems: systems requirements to comply with new standard, processes for implementing new standard, internal controls for newly developed processes Change management: training materials for new processes, communication plan changes in compensation policies Page 28
How EY can help you Phase 4: implementation 1 2 3 4 5 Phase Diagnostic Design and planning Solution development Implementation Postimplementation EY can support you in: Rolling out actions developed in the prior phase to the organisation Examples of outputs from each work stream: Accounting and reporting: 2017 F/S (including cumulative catch-up adjustment and new disclosures), updated accounting policy manual (distributed to accounting professionals) Tax: updated tax accounting policies Business processes and systems: updated business process and policy manuals, fully implemented accounting system Change management: training sessions for professionals in all affected functions, memos from human resources on new compensation policies Page 29
How EY can help you Phase 5: post implementation 1 2 3 4 5 Phase Diagnostic Design and planning Solution development Implementation Postimplementation EY can support and advise you as you: Monitor organisational implementation efforts Identify necessary updates and changes to processes, systems and policies to support continuous improvement Monitor peer efforts Conduct status meetings Page 30
How EY can help you The EY Revenue Recognition Readiness (RRR) Tool Internal note: for channel 2 clients only An easy-to-use application that combines structured analysis, such as automation of standard calculations with documentation, and a clear audit trail of key management judgements and estimates through each step of the new model. The EY RRR Tool may help you with the (depending on your needs): Identification and documentation of the key contract terms with customers Evaluation of the key terms against the proposed five-step model Consideration and documentation of judgements and conclusions Collection of data to support disclosure requirements Page 31
How EY can help you The EY Revenue Recognition Readiness (RRR) Tool Internal note: for channel 1 clients only An easy-to-use application that combines structured analysis and a clear audit trail of key management judgements and estimates through each step of the new model. The EY RRR Tool may help you with the (depending on your needs): Identification and documentation of the key contract terms with customers Evaluation of the key terms against the proposed five-step model Consideration and documentation of judgements and conclusions Collection of data to support disclosure requirements Page 32
How EY can help you EY cloud-based site Internal note: for channel 2 clients only EY s cloud-based site provides an easy-to-use one-stop shop for all of your project management, information and analytical tool needs. The implementation methodology and framework in EY s site can easily be customised to accommodate your project structure and reporting needs (e.g., business units, work streams, regions, phases, project type, revenue streams, and individuals). Page 33
About EY Page 34
About EY Our commitment EY s sector-specific insights and understanding of current market trends, combined with our technical experience, will help to successfully deliver on your revenue recognition implementation project. EY can provide practical and innovative services to address the financial reporting challenges resulting from changes in the economic and regulatory environment. The FAAS team will lead a multidisciplinary team to deliver our integrated service offering to meet your needs. Page 35
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Contacts Andrew Davies EMEIA FAAS IFRS 15 Revenue Recognition Leader adavies2@uk.ey.com +44 207 951 3237 Add photo John O Connell EMEIA FAAS IFRS/Life Sciences joconnell@uk.ey.com +44 207 951 2725 Page 37
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