requires a reporting entity to determine the nature of the obligation it incurs when it enters an R&D funding arrangement. This guidance requires consideration of whether that arrangement is (1) an obligation to repay the funding party or (2) a contract to perform services.
In order to conclude that an obligation to repay the funding party does not exist under ASC 730-20
, the transfer of financial risk associated solely with R&D from the reporting entity to the financial investor (or another counterparty) must be substantive and genuine. A critical factor is to determine who bears the risk of R&D failure and whether the reporting entity is obligated to repay any of the funds, regardless of the outcome of the research and development.
The transfer of financial risk associated with R&D may not be genuine if the reporting entity is committed to repay any of the funds provided by the other parties regardless of the outcome of the R&D. ASC 730-20-25-4
includes examples in which the reporting entity is committed to repay, which include:
- the entity guarantees, or has a contractual commitment that assures repayment of the funds provided by the financial investor regardless of the outcome of the R&D;
- the financial investor has rights to substitute R&D projects if the initial project is not successful and such substitution provides the financial investor with the ability to recoup some or all its funding;
- the financial investor can require the reporting entity to purchase their interest in the R&D regardless of the outcome; or
- the financial investor automatically receives debt or equity securities of the reporting entity upon termination or completion of the R&D regardless of the outcome.
In addition, although R&D funding arrangements may not include contractual provisions that require the reporting entity to repay any of the funds, conditions may indicate that the reporting entity is likely to bear the risk of failure of the R&D and will be required to repay all or a portion of the funds. If any portion of the funds provided by the investor must be repaid regardless of the outcome of the R&D activities, a repayment liability has been incurred under ASC 730-20
includes examples of such conditions leading to the presumption that the reporting entity will repay the counterparties, including:
- the reporting entity has indicated its intent to repay all or a portion of the funds provided regardless of the outcome of the R&D;
- the reporting entity would suffer a severe economic penalty if it failed to repay any or all of the funds provided to it regardless of the outcome of the R&D;
- a significant related party relationship between the company and the party funding the R&D exists at the time the company enters into the arrangement; or
- the reporting entity has essentially completed the project before entering into the arrangement.
As indicated above, is if there is a significant related party relationship between the reporting entity and the parties funding the R&D activities, there is a presumption that the reporting entity will repay the counterparties. Whether a related party relationship is “significant” is a matter of judgment that will be influenced by the relative interests of the related parties in the funding parties and the R&D entity, as well as the presence of any influential parties (e.g., officers or directors of the funding parties) as investors in the R&D entity. ASC 730-20-S99-1
provides the SEC staff's views on what constitutes a significant related party relationship.
Excerpt from ASC 730-20-S99-1
Question 1: What does the staff consider a "significant related party relationship" as that term is used in FASB ASC subparagraph 730-20-25-6(c)
Interpretive Response: The staff believes that a significant related party relationship exists when 10 percent or more of the entity providing the funds is owned by related parties. In unusual circumstances, the staff may also question the appropriateness of treating a research and development arrangement as a contract to perform service for others at the less than 10 percent level. In reviewing these matters the staff will consider, among other factors, the percentage of the funding entity owned by the related parties in relationship to their ownership in and degree of influence or control over the enterprise receiving the funds.
In some R&D arrangements, particularly those involving start-up companies, it may be unlikely the reporting entity will have the financial resources to repay the funds when the R&D efforts are completed. However, this does not eliminate the requirement for the reporting entity to record a repayment liability for the R&D funds received, since ASC 730-20-25-3
acknowledges that the liability may be repaid by the issuance of securities or by some other means. This is consistent with ASC 730-20-S99-1
, which states that "an apparent or projected inability to repay the funds with cash (or debt which would later be paid with cash) does not necessarily demonstrate that the funding parties were accepting the entire risks of the activities."
Other examples in ASC 730-20-25-6
of conditions leading to the presumption that the R&D funds will be repaid is an indication of an intent to repay some or all of the funds, a "severe economic penalty" that would be suffered by the funding party if the funds were not repaid (e.g., loss of rights to a proprietary technology), or an R&D project that is “essentially completed” before entering into the arrangement. The list of examples included in ASC 730-20-25-6
is not all-inclusive and new provisions included in agreements or new conditions may arise that could have substantially the same effect. As a result of the general nature of the discussion in ASC 730-20-25-6
, judgment may be required to determine whether the presumption that the enterprise has an obligation to repay the other parties has been overcome.
If a substantive and genuine transfer of financial risk to the funding parties has occurred because repayment of any of the funds depends solely on the results of the R&D having future economic benefit, ASC 730-20-25-8
requires that the obligation be accounted for by the R&D entity as a contract to perform R&D services for others. As a result, any funding received by the reporting entity under the arrangement would generally be recognized through the income statement, the timing of which will depend on the terms and conditions of the arrangement. ASC 730-20
does not include specific guidance on how the funding received in such a scenario should be recognized in the income statement. As a result, reporting entities should evaluate the nature of the arrangement and its relationship to the entity’s normal, ongoing operations in determining how the funding should be recognized in the income statement (i.e., as contra-R&D expense, revenue from a contract with a customer under ASC 606
, a collaborative arrangement, other income).
Example PPE 8-9 illustrates the accounting for a direct R&D funding arrangement with no obligation to repay the funding.
EXAMPLE PPE 8-9
Direct R&D funding arrangement with no obligation to repay
Investor Co. partners with Pharma Corp. for the development of a pre-selected drug compound that is in Phase II clinical studies. Investor Co. and Pharma Corp. are not related parties. Funding is paid directly from the Investor Co. to Pharma Corp. (i.e., no separate legal entity is created) and Investor Co. commits up to a specified dollar amount to fund the R&D for the pre-selected compound. At the time of funding, successful development of the compound is not yet probable. Investor Co. will receive royalties from future sales of the compound if and when it is commercialized, contingent upon regulatory approval of the compound. Investor Co. will not receive any repayment if the compound is not successfully developed. Investor Co. has agreed with Pharma Co. on the selection of the compound and the overall development plan and budget but does not participate in any of the development or commercialization activities. The agreement requires Pharma Co. to use its best efforts to execute the development plan until regulatory approval or demonstration of failure. Pharma Corp. has concluded that the arrangement meets one of the derivative scope exceptions.
How should Pharma Corp. account for the funding received from Investor Co.?
Given the nature of the development and regulatory process, the activities undertaken as part of the project would meet the definition of R&D in ASC 730-10-20
. Based on the current phase of development, Pharma Corp. would likely conclude that R&D risk is substantive at the inception of the arrangement because successful development of the compound is not probable at that time. Accordingly, Pharma Corp. would apply ASC 730-20
to determine whether the funds received represent a liability to repay Investor Co. or an obligation to perform contractual services.
To conclude that a liability does not exist, the transfer of risk involved with the R&D from Pharma Corp. to Investor Co. must be substantive and genuine (i.e., it must not be probable that any of the funds would be repaid regardless of the outcome of the R&D). In this fact pattern, Pharma Corp. has no explicit or implicit obligation to repay any of the funds and there are no substitution rights or other arrangements that require Pharma Corp. to repay any of the R&D funds. As a result, Pharma Corp. would likely conclude that the arrangement is an obligation to perform contractual services. Because Investor Co. is not a customer and performing R&D activities for others is not part of Pharma Corp.’s normal, ongoing operations, Pharma Corp. may conclude that the funds should be recognized as contra-R&D expense in the income statement.