What's a Collaborative Arrangement?

The accounting guidance for the class of joint ventures known as “collaborative arrangements” is vague and may lead to inconsistency in financial reporting. Here’s how the Financial Accounting Standards Board (FASB) hopes to clarify its guidance on the subject and why accounting for collaborative arrangements could have an effect on the revenue recognition rules.

Collaborative-arrangement accounting

Companies set up collaborative arrangements largely to share costs. Accounting Standards Codification (ASC) Topic 808, Collaborative Arrangements, provides guidance for income statement presentation, classification and disclosures related to collaborative arrangements. It lists three requirements for collaborative arrangements:

  1. They involve at least two parties (or participants).
  2. The parties involved are all active participants in the activity.
  3. All participants are exposed to significant risks and rewards dependent on the commercial success of the activity.

Collaborative arrangements are a particularly common type of joint venture for biotechnology, pharmaceutical and life science companies. For example, two pharmaceutical companies might agree to share research and development expenses to produce a new drug. Then, if the drug succeeds, the companies also would share the revenue from sales of the drug.

When collaborative arrangements are set up as legal entities, the standards under U.S. Generally Accepted Accounting Principles (GAAP) are clear about how the payments between the partners should be accounted for. But GAAP is less specific about arrangements that don’t have a legal status.

In addition, Topic 808 doesn’t include recognition and measurement guidelines, such as guidance for determining the appropriate unit of accounting or when recognition criteria are met. Rather, it says to look to other areas of GAAP to account for a transaction. If there’s no formal guidance available, then businesses typically apply an accounting policy or another accounting method by analogy. This has led to a lot of inconsistent financial reporting practices.

Need for clarity

In October 2017, the FASB decided to clarify its accounting guidance for collaborative arrangements. The scope of this project, however, has expanded from when it was added to the agenda in November 2016.

The project’s original goal was to clarify when partners in a collaborative arrangement need to record revenue because of the venture’s cost reductions. Subsequently, the FASB decided to also examine 1) how to account for transactions that don’t create revenue for the partners, and 2) what constitutes a unit of account within Topic 808.

“Collaborative arrangements come in a variety of shapes and sizes, and all vary based off the individual facts and circumstances,” FASB practice fellow Amy Park said. “The recommendation we’re making isn’t a cure-all, not a panacea, not going to solve the problem completely, and quite frankly, there isn’t a single model that can do that.”

Revenue recognition standard concerns

Calls for clarity on collaborative arrangements have grown even louder as companies implement Accounting Standards Update (ASU) No. 2014-09, Revenue From Contracts With Customers (Topic 606). The updated standard limits application of the revenue standard to arrangements that involve a customer as one of the parties to a contract. It also says many joint ventures aren’t considered customer contracts unless one of the parties to the agreement is receiving the output from the joint venture’s activities.

Under today’s vague accounting rules for these arrangements, companies may label items as “revenue” when they belong elsewhere on the income statement. The FASB’s guidance on collaborative arrangements will affect timing of revenue recognition, as well as whether payments are deemed revenue, an offset to costs or another “nonrevenue” hit to profit and loss that the FASB might explore. Ultimately, the classification of revenue from a collaborative arrangement can have a major impact on a participant’s income statement.

What’s next?

The term “collaborative arrangement” means different things to different people. The FASB hopes to bring much-needed clarity and consistency to this gray area of financial reporting. In light of the correlation between the collaborative arrangement guidance and the new revenue recognition standard, expect the FASB to move quickly on this project: The revenue recognition standard goes into effect for public companies in 2018 and for private ones in 2019.

© 2017