SEC On Revenue; FASB EPS Guidance; More

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iotech companies, take note: An accounting position recently taken by the Securities and Exchange Commission could affect revenue recognition under new and existing collaborative arrangements that contain joint steering-committee obligations, lawyers at the law firm Cooley Godward Kronish say.

Under collaborative agreements, biotech companies research a new drug compound, and license its latter-stage development and marketing to larger businesses, such as a pharmaceutical company. The pharmaceutical company manages the sale of the drug once it’s approved, while the biotech company gains much-needed revenue prior to that through upfront fees, royalties, development funding, and milestones.

The companies typically form a joint governance or steering committee for information-sharing and coordination of efforts like this. Historically, such steering-committee obligations, which typically continue at least until the drug is commercialized, weren’t considered substantive, so they weren’t a deliverable, Cooley Godward partner Glen Sato says. But the SEC recently took the position that joint steering-committee obligations were a substantial “deliverable” under Emerging Issues Task Force No. 00-21, Revenue Arrangements with Multiple Deliverables.

The SEC made the decision in regards to Curis Inc., a biotech that last year restated three years’ worth of financials statements because of revenue-recognition issues stemming from collaboration and license agreements, where the joint-steering committee governing the collaboration didn’t have a defined termination date.

Sato

“The Curis case is a significant concern, as this is the first instance we are aware of in which a steering committee obligation with no definable term was considered significant,” Sato and partner Laura Berezin wrote in a Jan. 30 legal bulletin. “There appears to be a presumption now that a joint steering committee is a substantive obligation in these types of collaborations,” says Sato.

INTERPRETATION

The following text from Cooley Godward Kronish’s letter discusses the SEC’s recently released view.

What to do now

For those who are drafting agreements or who entered into collaboration agreements this past year, review closely and reach agreement with your auditors on the appropriate revenue recognition under the collaborative agreement. If you are currently drafting a collaboration agreement, consider a sunset provision for the steering committee (and subcommittees), the right to opt out of the steering committee after some specified time, or the clarification of whether there are any significant penalties for not participating in joint steering committee activities.

Review any current significant collaboration agreements to identify continuing substantive obligations (in particular but not limited to joint steering committee participation). It is likely that most of larger collaboration agreements have JSC’s with no specific termination or end date. Further note that significant obligations beyond JSC participation, such as manufacturing or supply commitments, should also be considered separately in the assessment. If you believe that your continuing obligations may present issues in recognizing revenue, then consider an amendment terminating at some specified time in the future those substantive obligations.

Source

Recent SEC View May Affect Revenue Recognition (Cooley Godward Kronish; Jan. 30, 2007; Excerpted With Permission)

The implication is that payments under the collaborative arrangements, such as the up-front fee milestones and maintenance fees, no longer would be recognized ratably, and even royalties would be accounted for as deferred revenue until the steering-committee obligations were terminated or otherwise identified along with the other separate units of accounting under the EITF 00-21 analysis. So while the biotech company would show cash on its balance sheet, it wouldn’t show any revenue on the income statement. “The company would be profitable on a cash basis, but it would still be a loss company,” Sato says.

Berezin

“Companies should look at their collaborative agreements to see whether they have a steering committee of any kind or similar issues and whether those have definable terms,” Berezin says. “If not, the company may want to amend those agreements to allow them to opt out of the committee at some point in the future.” (For more, see the recommendations to the right.)

The SEC hasn’t taken a policy position or provided written guidance yet on the issue, Berezin adds. The issue is currently under review and discussion at the SEC, but further guidance isn’t expected until much later this year. (For related resources, including the Cooley alert, the SEC comment letter, and Curis’ response, see the box, above right.)

FASB Gives Guidance On EPS Calculations

FASB wants feedback on proposed guidance regarding a three-step process of calculating earnings per share under the two-class method specified in FAS 128, Earnings Per Share.

FASB proposed Staff Position No. FAS 128-a, Computational Guidance for Computing Diluted EPS under the Two-Class Method, says that diluted EPS under the two-class method should be calculated using a three-step process that takes into account a second class of common stock.

Neuhausen

Ben Neuhausen, national director of accounting for BDO Seidman and a member of FASB’s Emerging Issues Task Force, says the two-class method has existed for some 35 years or more. But it was rarely used, he says, until EITF Consensus 03-6 broadened use of the two-class method “by expanding the definition of what constitutes a ‘participating’ security.” That’s important because FAS 128 requires the two-class method for any instance involving a participating security.

With the proposed guidance, “FASB has laid out an approach for companies to work through, step by step, to compute diluted EPS where you have participating securities in the capital structure,” Neuhausen explains.

Cathy Cole, an associate chief accountant at the SEC, says the two-class method affects more companies than most accountants realize. “In my opinion, the two-class method is an under-discussed topic in accounting,” she told an audience at a conference of the American Institute of Certified Public Accountants in December.

Cole says the SEC staff believes that for diluted EPS, a company with two classes of common stock “must actually present both a basic and diluted earnings per share number for each class of common stock regardless of conversion rights.” Cole acknowledged that the computation may get complicated when different classes of stock have different dividend rates and different voting rights, and when one class of stock may be convertible to another. She says companies should use the “if converted” method prescribed in accounting rules and present diluted EPS for both classes separately.

The key, Cole says, is to assure that the computation takes into account all relevant facts. “When applying the two-class method to several classes of common stock, one ought to consider all of the rights and privileges of the classes in determining the allocation of undistributed earnings to the individual classes of common stock,” she says. “And for good measure you may want to ask the staff about the issue as well.”

Audit Profession Reaches Out To Public Directly

The audit profession is banding together to plead its cause directly to the public with the Center for Audit Quality, a revamped arm of the American Institute of Certified Public Accountants.

The AICPA has operated the Center for Public Company Audit Firms as an entity to provide auditors of public companies with technical information and education. Now the AICPA and eight major audit firms have collaborated to expand CPCAF’s mission to address not just their own technical concerns, but to include the investing public in discussions about audit quality.

Fornelli

Cynthia Fornelli, executive director of the reorganized center, says the CAQ will bring together public company auditors and public leaders in investor and corporate communities to discuss the complex issues facing global capital markets. The goal is to contribute to the discussion developing among regulators and others about how to improve the quality, relevance, and integrity of financial reporting, she says.

The major audit firms issued a report last fall calling for a new direction in financial reporting and making their case for protections from excessive auditor liability. They said an “expectation gap” between what an audit should do and what investors expect it to do is driving unrealistic expectations about the level of assurance audits are supposed to provide.

Fornelli says those issues will be on the CAQ’s agenda. “In terms of narrowing the expectations gap, we will work to pursue approaches that will help issuers and auditors address fraudulent financial reporting,” she says. “By working with regulators, standards-setters, the center’s members, and other market participants, we believe we can find practical ways to come closer to meeting public expectations through standards, transparency, performance, and other changes in the policy and legal environments.”

Auditors aren’t the only ones concerned about auditor liability, she adds. “The continued availability to investors and the capital markets of the auditing function is critical and it is something we will look at as well,” she says.

Fornelli says one of the center’s major initiatives will be a series of forums throughout the United States that will bring together preparers and users of financial reports as well as regulators, to hash out the problems and brainstorm prospective solutions.

“These are difficult questions and complex answers,” she says. “It’s important that everyone who benefits from the information [is] part of the discussion on how to modernize and enhance it.”