Another common form of an R&D funding arrangement is often referred to as “direct” R&D funding. Typically, direct R&D funding arrangements involve an investor providing direct funding to the reporting entity for a specified R&D project in return for future payments (e.g., milestone payments, royalties on sales) contingent upon successful completion of the R&D. When evaluating the accounting model for direct R&D funding arrangements (particularly in situations when a new legal entity is not established), a reporting entity should assess whether the arrangement is within the scope of ASC 730-20, Research and Development Arrangements, or ASC 470-10, Debt - Overall. In addition, a reporting entity should consider whether the arrangement either meets all of the characteristics of a derivative or contains an embedded derivative, and if so, whether any of the scope exceptions to derivative accounting are applicable.

ASC 730-20 provides guidance on the accounting by an entity that is a party to an R&D arrangement in which it can obtain control of the results of R&D that is funded partially or entirely by others. ASC 470-10-25 (the “sales of future revenues guidance”) provides guidance on the accounting by an entity that receives a payment of cash from an investor and in exchange, agrees to pay the investor a specified percentage or amount of revenue for a particular product line, business segment, trademark, patent, or contractual right for a defined period of time.

To determine which guidance should be applied to the arrangement, the entity receiving funding must first evaluate the nature and substance of the risk associated with the stage of development of the R&D program being funded. If the reporting entity concludes that successful completion of the R&D program is probable at the inception of the arrangement, or the R&D program has already been completed and the related product has been approved (e.g., FDA approval of a new drug), ASC 470-10-25 should be applied. Under this guidance, the classification of the proceeds from an investor as either debt or deferred income will depend on the specific facts and circumstances of the arrangement. However, ASC 470-10-25-2 includes several factors that would create a presumption that the proceeds received should be classified as debt.

Alternatively, ASC 730-20 should be applied if, at the inception of the funding arrangement, the R&D risk is substantive and it is not yet probable that development will be successful. If any conditions exist that suggest it is probable an entity will repay any or all of the funds provided by another party regardless of the outcome of the R&D, an obligation should be recorded by the R&D entity for the amount to be repaid, even if there is no contractual obligation to repay. See PPE 8.3.4.3 for additional information on determining whether an arrangement represents an obligation to repay the funding party or a contract to perform services.

Certain funding arrangements that incorporate other significant risks (including legal, business, operational, time-to-market, etc.) should be evaluated to determine the applicable guidance. For example, if the predominant risk to the third-party investor’s ability to recoup its investment relates to the outcome of patent litigation, it may not be appropriate to evaluate the arrangement under ASC 730-20.

ASC 730-20 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:

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.

ASC 730-20-25-6 includes examples of such conditions leading to the presumption that the reporting entity will repay the counterparties, including:

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.

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.

ASC 730-20 does not include specific guidance with respect to the subsequent accounting for funds recognized as repayment obligations. In the absence of specific guidance, we believe when an obligation to repay the funding party has been incurred, the reporting entity should apply the concepts of ASC 470, Debt, in accounting for the repayment obligation.

ASC 730-20 also does not address the common situation when the amounts expected to be repaid to a lender exceed the R&D costs to be incurred. If the repayment obligation is expected to exceed the amount of the cash or other proceeds received, such excess should be accounted for not as R&D costs, but instead as interest cost over the estimated period of the obligation, following the guidance of ASC 835, Interest.

ASC 730-20-25-11 addresses situations in which a funding entity provides a loan or advance to another party that uses the funds to perform R&D. This guidance requires that if repayment of the loan or advance to the funding entity depends solely on the results of the research and development having future economic benefit, the loan or advance should be accounted for as R&D costs incurred by the funding entity. Consistent with the guidance of ASC 730-10-25-2(d), in situations when a reporting entity contracts with another party to perform R&D activities, the costs of services performed should be recorded as R&D costs in the period services are provided. This may require obtaining periodic progress reports and status updates from the third-party in order to assess the level of effort and progress to date.

Further, ASC 730-20-25-13 indicates that nonrefundable advance payments for future R&D activities should be deferred at the time of payment and subsequently recognized as R&D expense as the related goods are provided or services are rendered. These amounts should be reassessed on a periodic basis to determine whether it is probable that the goods or services will be provided under the arrangement. If a reporting entity does not expect that the goods will be provided or services will be rendered, the advance payment should be immediately recognized as an R&D expense.

In cases when interest is incurred on a loan to finance R&D activities, borrowing costs should be expensed as incurred. This is because R&D activities do not result in a qualifying asset for interest capitalization under ASC 835-20-15-5.

Example PPE 8-10 illustrates the accounting for a nonrefundable upfront payment made to another entity to conduct research on a contractual basis.

EXAMPLE PPE 8-10
Accounting for nonrefundable upfront payment to conduct R&D

Pharma Corp enters into a contract with Research Corp, a third-party professional research organization, to perform research activities for a period of three years in connection with a drug compound for a cancer treatment. Pharma Corp pays Research Corp a non-refundable upfront payment of $5 million to carry out the research under the terms of the contract. Research Corp is responsible for providing Pharma Corp monthly updates on the status of research activities performed. Pharma Corp has the ownership rights to all research performed, including the ability to control the research undertaken. Research Corp has no rights to use the rights of its research for its own purposes.

How should Pharma Corp account for the $5 million upfront payment made to Research Corp?

The non-refundable upfront payment is for services that will be rendered for future R&D activities under an executory contract. In accordance with ASC 730-20-25-13, the $5 million upfront payment should be recorded as a prepayment and recognized as R&D expense based upon the pattern of performance (i.e., level of effort) as services are rendered by Research Corp. Pharma Corp should reassess each reporting period whether it expects the services to be rendered by Research Corp in order to assess recoverability of the prepayment.

See FSP 3.6.5 for the presentation and disclosure requirements for research and development arrangements.

Reporting entities may enter into contractual arrangements to participate in a joint operating activity to develop and commercialize intellectual property (e.g., the development and commercialization of a new drug, software, computer hardware, or a motion picture). Such arrangements, referred to as collaborative arrangements, involve two or more parties that are (1) active participants in the joint operating activity and (2) exposed to significant risks and rewards dependent on the commercial success of the activity. ASC 808-10-15-9 indicates that those arrangements in which one party only provides funding or other financial resources for R&D activities and is not otherwise an active participant in the activities generally would not meet the definition of a collaborative arrangement. Alternatively, R&D arrangements between two parties that involve active co-development or co-marketing may meet the definition of a collaborative arrangement if certain criteria are met.

Reporting entities should consider whether R&D funding arrangements, or part of these arrangements, are within the scope of ASC 808, Collaborative Arrangements, when determining the appropriate income statement presentation, classification, and disclosure. See RR 2.4.1 for further discussion on collaborative arrangements.