New rules for revenue recognition are working their way through the life-sciences industry, and diagnostics companies and labs stand to be significantly impacted—especially in how they evaluate the following:
• Contract components and terms
• Timing and extent of collectability of payments
• Transaction pricing
As with any business decision that needs to recognize both rules and reality, judgment on the part of leadership will be required.
Legacy guidance mandates the application of the concept of persuasive evidence, such as an agreement or purchase order, to provide evidence of the ultimate understanding between customer and seller regarding the terms and nature of a transaction. The new standard alternatively requires an entity identify contracts with customers.
Although persuasive evidence may have already been in the form of a traditional contract, it also might have been a purchase order or another document that demonstrated both sides understood the nature of a transaction. Evaluating these items is key to adhering to the new guidance.
Five Elements of a Contract
Contracts may be written, verbal, or implied, but they must contain five key components:
• Approval of a contract and commitment to perform
• Identifiable rights between both parties
• Identifiable payment terms
• Definition of probable collection
• Evidence of commercial substance
Judgement must be exercised when determining whether an agreement is a contract. Most diagnostics providers have some record of their patient relationships. Those providers will need to evaluate those documents to determine whether a contract exists and whether it’s enforceable. The complexity lies in the provider, patient, and payer relationship.
Determining Payment Collectability
Reasonably assured collectability of full payment from a customer is no longer required to recognize revenue. Instead, it’s the customer’s intent and ability to pay that matters.
Under the new standard, a provider that may not be paid the full amount of its contract price may still be able to recognize the revenue under the arrangement. Factors that may be considered when determining collectability include the following:
• Patient’s past payment history
• Patient’s eligibility for coverage under Medicare or similar government subsidies
In evaluating collectability, diagnostic providers don’t need to evaluate individual tests or accessions. Instead, they can allocate delivered tests into portfolio groups based on similar collection history or reimbursement rates—by payer and test type, for example—to determine whether the collectability standard has been met.
Establishing Transaction Prices
Because the cost of services can often influence a patient’s intent and ability to pay, the method by which companies set transaction prices are changing.
Rather than requiring a provider to establish a fixed or determinable price to recognize revenue, the new standard introduces the concept of variable consideration. Under variable consideration, if a provider is willing to accept a lower price than what’s stated in a contract— whether implied through past experience or via discounts, rebates, price concessions—that amount must be factored into determining the transaction price.
For implicit price concessions, entities need to consider historical, current, and anticipated information to estimate the true transaction price.
Practical Implications for Public and Private Companies
The new standard took effect for public companies at the beginning of 2018. This means private companies beginning to plan for implementation of the standard in 2019 may look to their public peers for help interpreting the new guidance and identifying the impact the rules are already having on companies.
Recent Form 10-Ks filed by companies in the diagnostic space show us two major impact areas:
• Acceleration of revenue recognition as companies move from cash to accrual accounting
• Recharacterization of bad debt to revenue reduction
Acceleration of Revenue Recognition
Under the new standard of variable consideration, providers must record an estimate of the transaction price as revenue at the time of delivery. The estimate is then monitored and adjusted as necessary based on actual collection experience.
This may result in the acceleration of revenue recognition because a provider will no longer have the option to defer recognizing revenue until cash receipt due to uncertainties around transaction price and collectability.
Recharacterization of Bad Debt
Certain amounts that were classified as bad-debt expense under previous guidance may now be considered an implicit price concession in determining transaction price. This means those amounts may be accounted for as a reduction in net revenue instead of a bad-debt expense recorded under general and administrative expenses.
Many of these changes to policies, procedures, and results will impact how companies interpret information. Accordingly, businesses will need to use all reasonably available information—and their best judgment—to identify whether contracts exist, collectability is understandable, and transaction prices are clear.
Alyssa Strobel is a senior manager at Moss Adams and serves private and public companies in the life science, technology, and manufacturing industries, focusing on financial statement audits and SEC reporting, and other compliance services. Alyssa can be reached at (858) 627-1421 or email@example.com.
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