Direct Drugs Inc. (Direct) is planning to acquire SolvGen Inc. (SolvGen or the Company), a publicly owned company, during the fourth quarter of fiscal year ending December 31, 2006. Direct has engaged our audit engagement team to perform due diligence procedures, with an emphasis on the review of two separate material agreements: (1) a research and development agreement and (2) a license and distribution agreement, both executed by SolvGen during the first quarter of fiscal year 2006. Direct's management provided the engagement team with the following memo describing the Company's revenue recognition policy:
MEMO
To: Audit Engagement Team
From: CFO, SolvGen Inc.
Subject: Revenue Recognition for Research and Development and License and
Distribution Agreements
Date: November 30, 2006
SolvGen Inc. (the Company), an SEC registrant, is a pharmaceutical development company. SolvGen entered into a five-year research and development agreement with Careway Pharma Inc. (Careway) on January 1, 2006. The research and development agreement calls for SolvGen to use its best efforts to further develop proprietary instrument systems that have been under development for nearly 18 months and are expected to be ready for commercial launch in the near future. In connection with executing the research and development arrangement, SolvGen and Careway also entered into a five-year license and distribution agreement dated January 1, 2006.
Under the terms of the research and development agreement, SolvGen retains all intellectual rights to the results of the research and development agreement (even in the event of default by the Company). In connection with this agreement, SolvGen is entitled to the following nonrefundable milestone payments from Careway:
1. Exclusive negotiation payment - $1 million (paid December 1, 2005).
2. Contract signing payment - $2 million (paid January 1, 2006).
3. Commercial launch of instrument system Version 1 - $5 million (paid March 31, 2006, upon commercial launch of the instrument system).
4. Commercial launch of instrument system Version 2 - $5 million (not yet paid).
5. Commercial launch of instrument system Version 3 - $5 million (not yet paid).
Under the five-year license and distribution agreement, Careway will have the right to market and distribute the proprietary instrument systems. The license and distribution agreement requires Careway to pay SolvGen for each proprietary instrument system as it is purchased by Careway.
In accounting for the research and development and the license and distribution agreements, SolvGen recognizes the nonrefundable milestone payments when the payments are received over the remaining estimated contractual life of the agreements.
Required:
In deciding how to account for the research and development and the license and distribution agreements, address the following issues:
• What are the deliverables for the arrangement described in the case study above?
• When should the milestone payments received to date by SolvGen be recognized as revenue?
• Would your answer to the first requirement change under IFRSs? Explain your rationale supported by the guidance.
• Provide FASB number and IFRS number that applies or supports each question.