We wanted to alert you to an accounting position taken by the SEC for a few registrants that could be more broadly applied to other registrants in the biotechnology industry. The SEC’s interpretation potentially impacts revenue recognition under new as well as existing collaborative arrangements that contain joint steering committee obligations. We are advising our clients to carefully review and consider the issues raised in this Cooley Alert in order to avoid a potential restatement and to consider appropriate accounting treatment for collaboration payments in advance of an initial public offering.
Under Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition, the company generally performs an analysis regarding how it will recognize the various elements of revenue under the agreement. Under SAB No. 104, the criteria for revenue recognition is based upon the following: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred or services have been rendered; (c) payments received or expected to be received are fixed or determinable fees; and (d) collectibility is reasonably assured. Typically, because biotechnology collaboration agreements contain multiple deliverables, a related analysis under Emerging Issues Task Force No. 00-21 ("EITF 00-21"), Revenue Arrangements with Multiple Deliverables, is performed in order to identify using other applicable GAAP guidance, the amount of revenue that may be recognized from a separation of the various elements that comprise revenue under the arrangement.
Since the term "deliverable" is not defined in accounting literature, the use of judgment may be required to determine if an item included in an arrangement is a deliverable. A deliverable may be an obligation to provide goods, an obligation to deliver services, a right or license to use an asset, or some other vendor performance obligation that was bargained for as part of the arrangement. In general, we believe that an item should be presumed to be a deliverable if (1) it is explicitly written as an obligation for the vendor, (2) requires distinct action from the vendor, (3) the vendor’s failure to complete the action imposes a significant contractual penalty, or (4) inclusion or exclusion of an item would significantly change the arrangement consideration. The facts and circumstances of each arrangement should be reviewed to determine if an item is a deliverable.
Under EITF 00-21, where the deliverables do not have standalone value or where there is no objective fair value of undelivered items or where a general right of return exists, but delivery of undelivered items is not probable or not within the control of the licensor, then a party would not account for the deliverable as a separate unit of accounting. When the separation criteria are not met, the deliverables are accounted for as a combined unit of accounting. Revenue recognition for a combined deliverable would be dependent on the specific facts and circumstances. In many cases, the revenue recognition guidance applicable to the last deliverable may need to be followed for the combined unit of accounting.
Practically speaking, the application of EITF 00-21 based on the recent examples would result in deferral of revenue recognition for payments, including the up-front fee, research payments, milestones and royalties through a significant portion of the collaboration. Historically, licensors and their auditors in reviewing revenue recognition in a typical collaborative arrangement focused on performance obligations such as the delivery of research and development, manufacturing and commercialization services as substantive performance obligations to be analyzed under EITF 00-21.
Beginning in 2006, we witnessed a few registrants and the SEC take the position that joint steering committee obligations were a substantial "deliverable" under EITF 00-21. Because the joint steering committee obligations for some collaborations are of an uncertain term, these registrants concluded that the term of the obligation could not be reasonably estimated. Because the revenue recognition for a combined unit of accounting typically follows the accounting applicable to the final deliverable, no revenue will be recognized by these registrants until the term of the joint steering committee obligation can be estimated. For these registrants, the characterization of what has traditionally been viewed as a governance commitment created significant issues in revenue recognition under EITF 00-21.
Generally, we believe that most collaborative agreements have up-front fees, license maintenance fees and milestones recognized ratably as revenue over an identified period of performance under the agreement. Milestones and R&D funding, where matched to performance of obligations and related costs incurred by the licensor, are often recognized when achieved, in the case of milestones, or over the performance period in the case of R&D payments. The treatment under EITF 00-21 where the joint steering committee is considered a separate, undelivered deliverable would result in deferral of recognition of revenue of many of these payments, including not only the up-front fees but also milestones, research payments, royalties and product revenues, until the separate units of accounting can be identified or until the term of the obligation can be identified. Deferral of recognition of revenue would be significantly different from the traditional position clients have taken that (a) ratable recognition on a straight line basis such as patent term, as the outward end of the life the product, is appropriate and straight-line amortization over that period of time is acceptable; or (b) some proportionate performance based on a ratio of the services delivered to the total level of effort anticipated over the collaboration could support recognition of revenue over time.
The implication of the recent experience with the SEC is that payments under the collaborative arrangements such as the up-front fee, milestones and maintenance fees would no longer be recognized ratably and even royalties would be accounted for as deferred revenue until the steering committee obligations were terminated or otherwise qualified as separate units of accounting under the EITF 00-21 analysis. We are working closely with accounting firms and discussing this with the SEC in an effort to obtain clearer guidance in drafting agreements to address this issue.
In the first quarter of 2006, as part of an ordinary course review of the 2005 Annual Report on Form 10-K of Curis, Inc., guidance from the SEC raised significant issues regarding a company’s ability to recognize revenue in collaborations in which our clients are typically performing work or undertaking obligations for some period of time. Curis had to restate financial statements for 2.75 years as a result of revisiting revenue recognition following the EITF 00-21 analysis.
The Curis transaction involved a collaboration and license agreement in which Curis licensed certain rights to a small molecule against a specified target, two years of research for development small molecules and antibodies against the target. Curis retained a co-development right in a specified indication in the U.S.
The underlying issue raised in the SEC’s review of the Curis financial statements was that the joint steering committee ("JSC") governing the collaboration did not have a defined termination date. Curis identified the JSC as an ongoing substantive obligation. As a result, without a fixed termination date or the basis for stating that participation was perfunctory or inconsequential, the JSC became one of a number of obligations without stand-alone value or separate fair value. In this situation, in the absence of standalone value or an objective fair value, the JSC could not be viewed as a separate unit of accounting from the R&D services and license. As a result, under EITF 00-21 Curis was previously incorrect in recognizing revenue from the up-front and maintenance fees over a period prior to the time in which the participation on the JSC is expected to become inconsequential or perfunctory.
The Curis case is a significant concern as this is the first instance we are aware of in which a steering committee obligation with no definable term was considered significant. We’ve recently experienced this first-hand with another client that resulted in months of delay in discussing prospective revenue recognition under a recent collaboration agreement, and ultimately resulted in our client having the prospect of either (a) deferring revenue from up-front fees, royalties or profits for research and manufacturing services for an indefinite period, or (b) having to amend the agreement with its partner to truncate commitments such as JSC participation prior to commercialization in order to recognize revenue from those sources.
We believe that this issue will be most significant for parties who have some co-development responsibilities (or conduct separate development in different indications but have obligations to share data or the like). Nevertheless other arrangements in which there is research or development being conducted or where there is a continuing obligation to supply will call into question the revenue recognition for payments received under the collaboration. Obviously, the analysis will be fact specific but it is important to note that some of the obligations that have historically been considered perfunctory or non-substantive may not be viewed in that light for accounting analysis.
This issue is currently under review and discussion at the SEC. We do not expect further guidance until much later this year on this topic. As a result, we are strongly encouraging our clients to consider the implications of this uncertainty in the preparation and review of their collaboration agreements.
What to do now
- For those who are drafting agreements or who entered into collaboration agreements this past year, review closely and reach agreement with your auditors on the appropriate revenue recognition under the collaborative agreement. If you are currently drafting a collaboration agreement, consider a sunset provision for the steering committee (and subcommittees), the right to opt out of the steering committee after some specified time, or the clarification of whether there are any significant penalties for not participating in joint steering committee activities.
- Review any current significant collaboration agreements to identify continuing substantive obligations (in particular but not limited to joint steering committee participation). It is likely that most of larger collaboration agreements have JSC’s with no specific termination or end date. Further note that significant obligations beyond JSC participation, such as manufacturing or supply commitments, should also be considered separately in the assessment. If you believe that your continuing obligations may present issues in recognizing revenue, then consider an amendment terminating at some specified time in the future those substantive obligations.
More details regarding this issue and the treatment elected by Curis may be found in the SEC comment letter and response regarding Curis.