In this situation I would argue that ASC 730-20 is applicable. Pharmagen is entering into an agreement with PEI (investors) on a contractual basis to provide services and an option to acquire the results of the R&D (FASB 68). Pharmagen retains all ownership rights to the development of X. It also states that in R&D arrangements the entity (in this case Pharmagen) usually has an option to either purchase the partnership’s interest (PEI) or to obtain the exclusive rights to the entire results in return for a lump sum payment or royalty payments to the partnership (in this case PEI).
This clearly fits into Pharmagen’s case since PEI is entitled to receive future royalties from Pharmagen in return for contributions (funds) for the development of X. PEI will receive royalties associated with future revenues of X (if and when X has been successfully developed, approved by a regulatory agency, and commercialized for sale and future royalties associated with an existing commercialized drug for a defined period. These royalties represents a form of contingent payment.
The agreement does not specify that Pharmagen is committed to repay a liability but the conditions of the case infers this and can be argued that Pharmagen is committed to repay since the investors (PEI) are entitled to these royalties. Also an entity that is a party to an arrangement through which R&D is funded by other parties usually incurs an obligation when it enters into an agreement; which in this case the obligation is the royalties to PEI (investor). It would appear as if PEI (investors) is seeking some additional form of payment guarantees (royalty payments) for the use of the asset (ASC 730-20-05).
Pharmagen is not transferring all financial risk involved with R&D to PEI. According to ASC 730-20-25 in order to consider this not to be a liability the financial risk involved from the entity to the other parties must be substantive and genuine. Assuming that the funding received by Pharmagen is accounted for under ASC 730-20 (SFAS 68) and the entity is obligated to repay any of the funds provided by the other parties (PEI) regardless of the outcome of R&D, (in this case the repayment are being made by the royalty payments) the entity shall estimate and recognize that liability.
This applies whether the entity may settle the liability by paying cash, by issuing securities or some other means. In this case the funds are non-refundable and Pharmagen is not obligated to complete the development of X. ASC 730-20-25-13 states “ Nonrefundable advance payments for goods or services that have the characteristics that will be used or rendered for future research and development activities pursuant to an executory contractual arrangement shall be deferred and capitalized. ” These amounts should be recognized as an expense as the related goods are delivered or performed.
If the entity does not expect the goods to be delivered or services to be rendered the capitalized advance payment should be charged to expense. In my opinion ASC 470-10-25 is not applicable since the R&D arrangement does not specify a defined percentage or amount of revenue that PEI will receive. ASC 470-10-25 states that “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 of a particular product line, business segment, trademark, patent or contractual right. Based on that statement there is no way for PEI to know exactly how much they will receive since there was no agreement made to repay even though the royalty payments can be considered to be a form of contingent payments. There is also the issue of the commercialized sales of the drug (X). It is not appropriate to classify these funds as debt since Pharmagen has significant continuing involvement in the generation of the cash flows due to PEI (EITF Issue No 88-18).