New revenue and lease guidance may fundamentally alter the way medical device companies report financial results in 2018—and beyond. And to add more pressure, medical device companies needed to act fast, as there were several other new financial reporting standards that had to be adopted by publicly traded companies in the first quarter of 2018 alone.
A new life sciences industry publication explores, in part, new rule changes from the Financial Accounting Standards Board (FASB) affecting medical device companies in depth and provides guidance on how life sciences financial professionals can address these reporting challenges. In particular, two rule changes may significantly change the timing of revenue recognition for medical device companies: 1) The new revenue standard and 2) the new lease standard. Life sciences financial professionals will need to exercise significant judgment in how they apply the rules to achieve compliance while also advising operational leaders on the financial impact of potential new contracts with customers.
Changes in: Revenue Recognition
The new FASB revenue standard effective for public companies this year requires medical device companies to comprehensively reassess their existing revenue accounting policies to determine whether changes are necessary. While the impacts of the standard may vary depending upon the nature of a medical device company’s revenue contracts, many companies are expected to experience changes in the timing of revenue recognition as a result of the elimination of the “contingent cap” concept. Specifically, under legacy revenue guidance, the allocation of a contract’s price to items delivered to a customer is limited to the amount of revenue that is not contingent on the delivery of future items. The new revenue standard does not include this same contingent cap.
Consider the example of a company that manufactures and sells infusion pumps along with intravenous solutions (consumables), where the pumps and solutions are considered separate “performance obligations.” The title to the pumps is transferred to the customer for free when the pumps are sold with a minimum commitment for the purchase of the consumables as well.
Previously, because the consideration to be received for the sale of the pump was contingent on the sale of the consumables, the medical device company would limit revenue recognition for the pump up to the amount of consideration that was not contingent on future sales. Because the pump was provided free of charge and all of the consideration from the arrangement is contingent on the sale of consumables, the company wouldn’t recognize revenue when control of the pump transferred to the customer.
Under the new revenue standard, the company must estimate the amount of consideration to which it expects to be entitled and allocate the consideration on a relative stand-alone selling price basis to each separate performance obligation. The result is that the medical device company in this example will likely recognize revenue earlier.
Changes in: Leases
The new lease standard, which is required to be adopted in 2019 for public companies, may also have an impact on revenue recognition for medical device companies that allow customers to use, rather than purchase, equipment that is required for medical device consumable products. To facilitate the sale of medical device consumables, medical device companies often place equipment for free at the customer’s location for a multi-year term. Previously under legacy lease guidance, this “placed equipment” may not have been considered an “identified asset” if the company could substitute it with other equipment, resulting in a potential conclusion that the placed equipment did not represent a lease. Under the new lease standard, to conclude the placed equipment does not represent an identified asset, the company must not only prove that it has the practical ability to substitute the placed equipment, but also demonstrate how it would benefit economically from doing so. As a result, it is possible that more arrangements that allow for placed equipment will represent an identified asset.
Take, for example, a company that supplies diagnostic kits to customers that can only be used with the company’s instruments. The company lets customers use the instruments for free in exchange for a multi-year agreement to purchase specified quantities of the kits. The term of the agreement corresponds with the expected useful life of the instruments. The medical device company retains title to the instruments and has the right to substitute them, although historically these instruments have been substituted only when they malfunction because the company doesn’t benefit economically from the substitution.
This contract to purchase diagnostic kits contains an embedded lease for the instrument system. Specifically, the instrument system is an identified asset because it is implicit that the company can fulfill the contract only through the customer’s use of the specific instruments. While the company has the right to substitute the instruments, the substitution right is not substantive because there’s no economic benefit from doing so. Customers also have the right to control the instruments’ use because they have the right to obtain substantially all of its economic benefits from the use of the instruments during the term of the arrangement which corresponds to the useful life of the instruments. Customers can also decide how and when the instruments are used when they perform diagnostic testing procedures.
The bottom line is more arrangements that contain placed equipment may include elements that meet the definition of a lease and be accounted for under the lease standard.
Far-reaching changes to accounting rules and standards may fundamentally transform how medical device companies report financial results in 2018 and beyond. Many companies may struggle to adapt. Those who evaluate the impacts of the new standards early will likely be in a stronger position to report financial results under the new standards, and advise operational leaders on the financial impact of potential new contracts. And those who understand change is constant will be ready for the next wave of change when it inevitably happens again.
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