How to account for outcome-based payment arrangements in life sciences

The trend of employing innovative pricing strategies to gain drug acceptance will likely continue to grow in the future, as ongoing pricing pressures are exerted by payors.

In our latest report, accounting for outcome-based payment arrangements in the life sciences sector, we discuss some of the accounting considerations for such arrangements when they are within the scope of the international financial reporting standards (IFRS) 15 revenue from contracts with customers.  

In outcome-based payment arrangements, the consideration to which an entity is entitled depends upon an outcome. Such arrangements are often referred to as “risk-sharing arrangements” (RSA).

When assessing how to account for an outcome-based payment arrangement, the first step is to determine whether the arrangement is within the scope of IFRS 15. Collaborative arrangements, for example, are typically outside the scope of IFRS 15. In the rest of our report, we consider only those arrangements that are within the scope of IFRS 15.

Overview of IFRS 15

The core principle of IFRS 15 is that an entity recognizes revenue at an amount that reflects the consideration to which the entity expects to be entitled in exchange for transferring promised goods or services to a customer. Life sciences entities, when determining the accounting treatment for their contracts with customers, need to go through each of the five steps outlined in IFRS 15 and consider all the specific requirements of the standard. This publication highlights only some of the key aspects when applying the five-step model to outcome-based payment arrangements.

The first step of the five-step model of IFRS 15 is identifying the contract with a customer. One of the criteria for qualifying as a contract with a customer is identification of the associated payment terms. When considering this criterion, it is important to note that the fact that the amount of consideration depends upon an outcome (e.g., the performance or actual results of the company’s drug, a cost-effectiveness target, a price, utilization or budget cap) would not, in itself, preclude the arrangement from being identified as a contract with the customer under IFRS 15.

Distinguishing between variable consideration and customer options

For outcome-based arrangements within the scope of IFRS 15 and that meet the IFRS 15 contract criteria, an entity must determine whether to apply the requirements for variable consideration or the application guidance for customer options. How to distinguish between the two types of arrangements is explained in the following sections.

Appropriately distinguishing between variable consideration and customer option may require the use of judgment and is important because it affects the accounting for the contract at inception and throughout the life of the contract, as well as the required disclosures.

Variable consideration (and constraint)

If the terms of the outcome-based payment arrangements are such that the prices for the products are adjusted retrospectively, such arrangements would give rise to variable consideration. This is because the final price of each product sold depends on its actual performance (or other factors). That is, the consideration is contingent on the occurrence or nonoccurrence of future events. IFRS 15 requires a life sciences entity to estimate variable consideration using either of the following methods, depending on which method better predicts the amount of consideration to which it will be entitled:

• The “expected value” method: Using this method, a life sciences entity determines the expected value of variable consideration using the sum of probability-weighted amounts in a range of possible amounts under the contract.
• The “most likely amount” method: In this method, a life sciences entity determines the amount of variable consideration using the single most likely amount in a range of possible consideration amounts.

Life sciences entities need to consider all information that is reasonably available when applying these methods.

The second step in estimating variable consideration requires life sciences entities to apply a constraint to all variable considerations. That is, an entity is required to include in the transaction price some (or all) of an amount of variable consideration, but only to the extent that it is highly probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.

When developing a reliable estimate for outcomes or assessing variable consideration constraints, a life sciences entity would need to consider a number of factors, including:

• Existence of commercial treatment data
• Experience in other markets where the drug is sold
• Length of time for which outcome data is available
• Determining whether the performance measure is based on an appropriately large population size
• Objectivity of the performance measure
• Length of the performance period
• Monitoring of the drug being administered

When a life sciences entity determines that it cannot meet the highly probable threshold if it includes all of the variable considerations in the transaction price, the amount of variable consideration that must be included in the transaction price is reduced. The amount included in the transaction price is limited to the amount that, if subsequently reversed when the uncertainty associated with the variable consideration is resolved, would not result in a significant reversal of cumulative revenue recognized. Therefore, even when there is significant uncertainty about the ultimate outcome of a contract, a life sciences entity should not automatically default to constraining the estimate of variable consideration to zero.

The assessment of variable consideration constraint may require significant judgment. The above factors are not intended to be all-inclusive, and the specific facts and circumstances of each arrangement must be considered.

Customer options for additional goods

If the payment terms of the arrangement imply a rebate, discount or free products applied prospectively after a certain number of doses, we believe the rebate, discount or free products generally would be accounted for as a customer option rather than as a variable consideration. This is because the consideration for the goods in the present contract is not contingent upon, or affected by, any future purchases and the volume rebates, discounts or free products affect only the price of future optional purchases.

If an option is a separate performance obligation, a portion of the transaction price is allocated to the option. Recognition of the allocated amount as revenue is deferred until the option is exercised or expires.

Concluding remarks

The accounting for outcome-based payment arrangements can be complex and is highly dependent on the specific facts and circumstances of each arrangement. Careful consideration of the facts and circumstances related to each arrangement will be necessary to determine the appropriate accounting treatment, as even relatively small variations in an arrangement’s terms or the related fact pattern may lead to a different conclusion.

Life sciences entities should include members of the finance function early in the process of structuring an arrangement, to avoid any unintended financial reporting consequences.