Pharmagen 9-2 Deloitte Trueblood Case

1.State the issue at hand. (Typically this is merely the question you are asked at the end of the case.) How to account for the funding of the R&D and royalty payments

2.State the fact pattern. BRIEFLY present the relevant facts. (Bullet points can be very useful here.) (This can be a challenge, given that some Trueblood cases are only a few paragraphs long, it can be hard to further summarize them.) •Pharmagen entered into a funding agreement with Company XYZ, an unrelated third-party private equity investor (PEI) •Pharmagen will receive $500 million from PEI for R&D costs associated with drug X •The funding is to be used solely for the development of X and may not be used for any other purposes •The funding is non-refundable and Pharmagen is not necessarily required to complete the development – “best efforts” arrangement •Pharmagen estimates $1 billion in total R&D costs over 3 years •Pharmagen retains the intellectual property rights of X

•There are no other agreements that have been executed between Pharmagen and PEI •Pharmagen estimates it will take 3 years to complete drug X from the execution of the agreement •The PEI will contribute funds to the development of X and is entitled to receive future royalties from Pharmagen in return oThe PEI will receive royalties associated with future revenues of X (if/when it has been successfully developed) oThe PEI will also receive future royalties associated with an existing commercialized drug for a defined period

3.Present your answer and the GAAP that supports your position. Use GAAP to explain why you chose the conclusion you did. Citing the appropriate paragraphs in the authoritative literature will definitely help your grade. Not citing the appropriate paragraphs in the authoritative literature will have the opposite effect. •Pharmagen should recognize the royalty that it owes the PEI for future royalties associated with an existing commercialized drug as soon as it is reasonably estimable. oASC 730-20-25-3 – “If the entity is obligated to repay any of the funds provided by the other parties regardless of the outcome of the research and development, the entity shall estimate and recognize that liability.”

•I believe Pharmagen should expense R&D costs as incurred. oASC 730-20-25-7 – “An entity that incurs a liability to repay the other parties shall charge the research and development costs to expense as incurred. The amount of funds provided by the other parties might exceed the entity's liability.” •Pharmagen needs to also disclose in the footnotes the terms of the royalty arrangements that it is to pay the PEI. oASC 730-20-50-1 – “An entity that under the provisions of this Subtopic accounts for its obligation under a research and development arrangement as a contract to perform R&D for others shall disclose both of the following: oa. The terms of significant agreements under the research and development arrangement (including royalty arrangements, purchase provisions, license agreements, and commitments to provide additional funding) as of the date of each balance sheet presented. ob.

The amount of compensation earned and costs incurred under such contracts for each period for which an income statement is presented.” •I believe Pharmagen should recognize the funding from the PEI as debt as opposed to deferred income. oASC 470-10-25-2 “While the classification of the proceeds from the investor as debt or deferred income depends on the specific facts and circumstances of the transaction, the presence of any one of the following factors independently creates a rebuttable presumption that classification of the proceeds as debt is appropriate.” The first thing stated is “The transaction does not purport to be a sale (that is, the form of the transaction is debt).”

4.Present other possible solutions and the GAAP that supports these positions. •Pharmagen could argue to recognize the funding by the PEI as deferred revenue because Pharmagen has agreed to pay the PEI a fixed royalty on both drug X and future royalties associated with an existing drug for a defined period. One could argue that the royalty is based on sales of a product that is not even developed yet. oASC 470-10-25-1 “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 or of a measure of income (for example, gross margin, operating income, or pretax income) of a particular product line, business segment, trademark, patent, or contractual right. It is assumed that immediate income recognition is not appropriate due to the facts and circumstances.”

5.Explain the flaws in these perspectives that make them less desirable than your preferred solution. Citing the appropriate paragraphs in the authoritative literature will definitely help your grade. Not citing the appropriate paragraphs in the authoritative literature will have the opposite effect. Further, consider conditions under which these solutions may become the preferred solution – what facts in the case would need to change for this to become the best answer.

The flaw in the alternative possible solution is that by recognizing the transaction as deferred income, you are not taking into account that the transaction lacks the substance as a sale. ASC 470-10-25-1 does say you can recognize it as deferred income, but it is sort of amended in the next section, ASC 470-10-25-2, where it states if the transaction does not purport to be a sale, recognition of debt is appropriate. The “best efforts” in the R&D phase of drug X means that the PEI is not holding Pharmagen accountable for producing a successful product. So long as Pharmagen is demonstrating progress towards the development of X, they will continue to receive incremental funding from the PEI.