Proposed changes in accounting rules highlight complexity for public companies.
Newly proposed changes to accounting rules may help public biotech and pharmaceutical companies and others avoid the nightmare scenario suffered by Impax Laboratories last year when the SEC revoked the registration of its common stock, essentially eliminating the public market for the company’s securities. The firm entered into a multiple-element strategic alliance with a distributor that eventually led to Impax spending more than $3 million over the course of several years to resolve the issue of when it should recognize revenue under the arrangement.
Impax, a publicly traded manufacturer of generic and branded pharmaceuticals, had inked an alliance with a distributor in which: (1) Impax would develop and produce 12 new generic products that the distributor would market under an exclusive license with profits shared by the two companies; (2) the distributor would lend Impax $22 million and purchase $15 million of its common stock; (3) Impax would repay the loan with shares of its common stock at its option; (4) interest and principal forgiveness were to occur to the extent that Impax met specific development milestones; (5) Impax was to repurchase a portion of its shares for nominal consideration when a specified milestone had been achieved; and (6) the parties were to share certain regulatory and patent litigation expenses.
To be sure, this arrangement had some unique characteristics, but even after beefing up its accounting staff, hiring outside consultants, and corresponding with the SEC over a period of years, Impax failed to file several annual and quarterly reports. The application of accounting principles to the deal proved to be too complex because of what accountants refer to as multiple deliverables, or bundling of various products and services together in one package, as well as payments based on achievement of certain milestones.
Revenue Recognition: An Elusive Target
In theory, deciding when a company should recognize revenue from a certain transaction should be simple. As even the SEC has acknowledged, though, there is no single, comprehensive accounting standard addressing revenue recognition. Rather, guidance can be found in a collection of accounting standards, pronouncements, and industry or transaction guidelines from various bodies.
Specifically, the SEC has designated the Financial Accounting Standards Board (FASB) as a private organization responsible for setting accounting standards for U.S. public companies. One arm of FASB, the Emerging Issues Task Force (EITF), holds public meetings to identify and resolve accounting issues occurring in the financial world.
Under existing FASB and EITF pronouncements, a company may generally recognize revenue from a transaction when: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) payments received or expected to be received are fixed or determinable fees; and (4) collectibility is probable. Applying these principles to particular pharmaceutical or biotech company transactions, though, can be anything but straightforward.
Complicating Factors: Multiple Deliverables and Milestones
Transactions involving multiple deliverables can be tricky when part of it has been delivered and part has not. In such transactions, to recognize revenue at the time of delivery of the initial portion of products or services, companies typically must obtain evidence of the fair value of any undelivered portions.
Because of the difficulty in establishing fair value in certain circumstances, some companies simply defer recognizing any revenue until all portions of the transaction have been delivered. Obviously, lengthy deferral of such revenue can be less than optimal from a business perspective and may not accurately reflect the economics of the deal.
A recent EITF proposal would permit company management to estimate selling prices of separate deliverables when fair value cannot be established and assuming other criteria are met. If adopted, multiple element arrangements will provide management with opportunities for more immediate and flexible revenue recognition.
The injection of greater management judgment, however, also creates the potential for increased after-the-fact scrutiny with the benefit of hindsight. Such scrutiny may result in unwanted attention from the SEC or private litigants.
A related complicating factor affecting biotech and pharma companies is the common use of milestones. EITF has proposed clarifying whether and when a company may recognize revenue as the milestones are achieved.
If FASB ratifies the proposed clarification, a company could generally recognize revenue attributable to the achievement of a particular milestone in the period in which the milestone is achieved (and when due and payable) so long as: (1) the milestone payment is nonrefundable; (2) the milestone is not reasonably assured at the inception of the arrangement; (3) substantive effort on the part of the company is involved in achieving the milestone; (4) the amount of the milestone payment is reasonable in relation to the effort expended; and (5) a reasonable amount of time passes between the up-front license fee and the first milestone payment. The simple passage of time or an event that results from the customer’s performance will not be considered a milestone under the proposal.
The Stakes Are High
Clarification and refinement of accounting rules for transactions involving multiple deliverables and milestone payments should be welcome developments for public biotech and pharma companies. The SEC’s enforcement division says that it will aggressively investigate and prosecute companies in any industry that fail to recognize revenue correctly, sometimes alleging false books and records or worse, securities fraud. The enforcement division consistently identifies financial disclosure fraud as one of its top priorities, and 20% to 30% of all SEC enforcement actions brought in any given year involve financial disclosure issues.
One recent case demonstrates the point even for fairly straightforward transactions. The SEC charged AXM Pharma and its CEO and CFO, Chester Howard, with securities fraud due to improper revenue recognition. The company, which had a license to manufacture and distribute branded products in Asia, executed a series of agreements with a distributor. The deals provided for the title to transfer upon delivery of the product to the distributor’s warehouse, payment after the distributor sold the goods to its customers, and a right of return for expired and other goods.
In one quarter, AXM received purchase orders from the distributor but failed to deliver over half of the product before the end of the quarter, and the distributor did not sell any of the purchased product. Despite having no history of the product being sold, AXM estimated that none of the product would be returned.
Despite all these red flags, the company recognized revenue in the full amount of the purchase order in that quarter, allegedly overstating revenue by 700%. Besides securities fraud, the SEC sought to permanently bar Howard from acting as an officer or director of a public company in the future.
Companies and individuals determined to falsify revenue will try to find new and creative ways to do so. They will nonetheless be faced with a formidable task because of the complexity of accounting rules and transactions involving multiple deliverables and milestone fees. Firms should pay careful attention to the proposed changes and clarifications to accounting rules in this area as well as their impact on operations and financial reporting.
Nicolas Morgan, partner at DLA Piper practices complex securities litigation.