Question

Bust-A-Knee Inc. (Bust-A-Knee) is a medical device company that specializes in developing knee replacement hardware. In 2020, Bust-A-Knee acquired 100 percent equity ownership of MD International (MD) for a purchase price of $15 million. MD is a pharmaceutical company that is developing two drugs: (1) a drug to cure cancer, Drug X, and (2) a pain medication, OuchX. Bust-A-Knee acquired the entity to expand into a new sector within the medical field. Bust-A-Knee concluded the acquisition of MD was a business combination. In purchase accounting, Bust-A-Knee recognized intangible assets for the in-process research and development (IPR&D) related to the ongoing development of Drug X and OuchX, among other acquired intangible assets. The IPR&D of Drug X and OuchX had acquisition-date fair values of $4 million and $3 million, respectively. During 2021, Bust-A-Knee determined its operations could not support the continued development of Drug X because significant efforts were being put forth in the development of OuchX. Since the date of acquisition, Bust-A-Knee had not invested any additional funding in the development of Drug X. Bust-A-Knee determined that there was no change in the carrying amount recorded on the date of acquisition. Rather than abandon the development project, Bust-A-Knee entered into an agreement with Pharmers Company (Pharmers) to transfer its ownership interests in (and control of) the IPR&D for Drug X. Pharmers, the market’s largest pharmaceutical company, will use Drug X’s IPR&D to continue its development, and obtain FDA approval to sell the drug on the open market. Selling IPR&D is not part of Bust-A-Knee’s ordinary activities and therefore Pharmers is not a customer of Bust-A-Knee (as defined by ASC 606). In return, Pharmers will pay Bust-A-Knee (1) a nonrefundable fixed fee of $2 million at contract execution; (2) a contingent future payment of $500,000, when Drug X is FDA approved; and (3) a 10 percent royalty fee based on the annual sales earned by Pharmers for the sale of Drug X in each of the subsequent five years following FDA approval. On the date of transfer, Bust-A-Knee estimates that the total consideration (nonrefundable fixed fee and contingent future fees) will be between $5 million and $6.5 million and that the weighted average expected amount of consideration Bust-A-Knee expects to be entitled to (at an 80 percent probability) is $5.5 million. Under the agreement, Pharmers paid $2 million when it obtained control of the IPR&D of Drug X and will pay the additional amounts if and when the associated contingencies related to such amounts are resolved.

Required: • On the date of transfer to Pharmers, how should Bust-A-Knee record the transaction?

Answer 1

Information given

1.Non refundable fixed fee of $2 million

2. A contingent future payment of $500,000, when Drug X is FDA approved; and

3.  10 percent royalty fee based on the annual sales earned by Pharmers for the sale of Drug X in each of the subsequent five years following FDA approval.

4. Fair value of Drug X $4 million

It has decided that Pharmers pay a nonrefundable amount of $2 million at inception plus a contingent future payment of $500,000, when Drug X is FDA approved; plus 10 percent of royalty fees based on the annual sales earned by Pharmers for the sale of Drug X in each of the subsequent 5 yrs.following FDA approval. The entity concludes that the sale of in-process research and development is not a good or service that is an output of the entity’s ordinary activities.

To determine the amount and timing of income to be recognized as follows:

a. The entity concludes that the criteria for identifying a contract are met.

b. The entity also concludes that it has transferred control of the in process research and development asset to the buyer as of contract inception. This is because as of contract inception the buyer can use the in-process research and development’s records, patents, and supporting documentation to develop potential products and the entity has relinquished all substantive rights to the in-process research and development asset

c. In estimating the consideration received, the entity determines the transaction price, including estimating and constraining variable consideration. However, the entity cannot assert that it is probable that recognizing all of the estimated variable consideration in other income would not result in a significant reversal of that consideration. In particular, the entity is aware that the variable consideration is highly susceptible to the actions and judgments of third parties, because it is based on the buyer completing the in-process research and development asset, obtaining regulatory approval for the output of the in-process research and development asset, and marketing and selling the output. For the same reasons, the entity also concludes that it could not include any amount, even a minimum amount, in the estimate of the consideration. Consequently, the entity concludes that the estimate of the consideration to be used in the calculation of the gain or loss upon the derecognition of the in-process research and development asset is limited to the $2 million fixed upfront payment.

At inception of the contract, the entity recognizes a net loss of $2 million ($2 million of consideration, less the in-process research and development asset of $4million). The entity reassesses the transaction price at each reporting period to determine whether it is probable that a significant reversal would not occur from recognizing the estimate as other income and, if so, recognizes that amount as other income.