Rate of return

Depending on the facts and circumstances involved In a particular research and development arrangement, true payments by the entity to the other parties ostensibly for royalties or to purchase the partnership's interests in or to obtain the exclusive rights to the research and development results might actually be any of the following: * a. The settlement of a borrowing ; b. The purchase price of an asset * c. The royalties for the use of an asset.

The financial reporting of an entity that is a party to a research and development arrangement should represent faithfully what It purports to represent and should not subordinate substance to form. " Without specific guidance and this as a launching point we need to look at this transaction and really see what's going on. From the agreement presented in the case this Is what I have been able to cull out of the extreme ambiguity.

The first piece of the agreement we should comb over Is the future royalties to be received by PIE from the sales of an established Pharmacy drug for a defined period of time. An established drug in the market has reasonably estimable future cash flows. I. E... Pilfer could predict with reasonably certainty sales of Vicarage this year. Thus, PIE Is constructively lending Pharmacy money now, with repayment of the borrowing coming in the form of royalties for a defined period of time.

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Lending money with recurring repayments of that principal over a defined period of time is essentially a bond. That Is also what Is going on here. The question is how much is PIE lending Pharmacy? If we accept that the future royalties associated with Pharmacy existing drug are reasonably estimable and for a defined period of time, we can do some math and discount the future cash flows and apply an appropriate return for similar debt Instruments' cash flows to arrive at exactly how much of Pep's money to Pharmacy Is constructive lending.

The number we arrive at for the constructive lending would be recorded as a note receivable (or more specific verbiage could be used) for PIE and a payable for Pharmacy in the form of a royalty payable to satisfy lending obligation. Now, as Pharmacy proceeds with their best efforts in developing drug X, and the amount of cumulative cash PIE has Infused Into Pharmacy at each threshold exceeds the amount previously quantified as constructive lending we have a new situation. The money is no longer lending, so what is it?

ACS 730-20-25-8 states: "To the extent Tanat ten Atlanta rills escalate Walt n ten research Ana development NAS Eden transferred because repayment of any of the funds provided by the other parties depends solely on the results of the research and development having future economic benefit, the entity shall account for its obligation as a contract to perform research and development for others. " If we look from Pep's point of view, they inserted the future royalties of the existing drug into the agreement as a guaranteed return of some of their invested capital.

We can assume the PEE fund isn't incompetent and understand that up to a certain investment point, presumably to the same dollar amount of expected cash flows from the existing drug royalties they are entitled to, they can't say that a return on investment drug X is more likely than not. However, once they start giving their incremental investments beyond the constructive lending amount we quantified earlier I think it is safe to say PIE sees a return on drug X as probable. So, PIE would need to record any cash sent to Pharmacy beyond the constructive lending amount as an investment, Just as any other investment is recorded.

They would need to be wary of impairment, perhaps, more so than other forms of investment, but this is strictly now an investment in Pharmacy. For Pharmacy, as stated in ACS 730-20-25-8 above, now has an obligation to perform research and development in the amount of any cash provided by PIE in excess of the constructive lending portion of the agreement. As we saw in ACS 730-20-05-9 at the top of this analysis of the agreement, there is an extreme amount of supposition involved in these types of R&D agreements and the code says they need to be accounted for with the substance of the transaction above the form.

I believe the aforementioned constructive lending portion and investment portion of the agreement satisfy the substance of the arrangement best under the circumstances presented. Also, the code itself seems to recognize its lack of ability to clearly delineate the proper accounting treatment and throws us a nice blanket piece of code to ensure the proper disclosure of the agreement in the form of 730-20-50-1 stating, "An entity that under the provisions of this Subtopic accounts for its obligation under research and development arrangement as a contract to perform research and development for others shall disclose both of the following: * a.

The terms of significant agreements under the research and development arrangement (including royalty arrangements, purchase provisions, license agreements, and commitments to provide additional funding) as of the date of each balance sheet presented * b. The amount of compensation earned and costs incurred under such contracts for each period for which an income statement is presented. " This Just means the agreement needs to be disclosed on both ends.

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