A collaborative arrangement (sometimes referred to in practice as “line-item” joint ventures or “virtual” joint ventures) is a contractual agreement between two or more parties (participants) to jointly conduct business activities for their mutual benefit without the formation of a separate entity in which to conduct the activities. These types of arrangements are commonly used for such purposes as producing motion pictures; designing and developing hardware and/or software; or developing new pharmaceutical drugs.
Determining the proper accounting treatment for the various activities included in these endeavors is the subject of EITF 07-1, Accounting for Collaborative Arrangements ratified by FASB on December 12, 2007, effective for annual and interim financial statements issued for fiscal years beginning after December 15, 2008.
Joint Operating Activities
As previously mentioned, collaborative arrangements are used to conduct many different types of business activities.
Examples of joint operating activities:
- Two or more parties may agree to collaborate on joint operation of a facility such as a hospital or long-term care nursing facility.
- Two professional services firms (e.g., architects, engineers, consultants) may choose to jointly submit a proposal to obtain a new engagement that neither would have the capacity and/or capability to perform on its own.
- A movie studio may collaborate with another studio because it wants to produce a film starring an actor that is under contract with another studio or two studios may wish to spread the cost (and, of course, the risk) of producing a film.
- Frequently, in the pharmaceutical industry, two companies engage in a joint operating activity to research, develop, market, manufacture, and/or distribute a drug candidate including the process of obtaining all necessary regulatory approvals in one or more geographic markets.
A collaborative arrangement may involve various types of activities conducted or supervised by the participants including, but not limited to research, development, branding, promotion, sales, marketing, order processing, package design, manufacturing, and distribution.
In some collaborative arrangements, a legal entity may be used for certain specified activities or in certain geographic jurisdictions due, for example, to legal restrictions imposed by the jurisdiction.
The participants’ roles and responsibilities vary between arrangements but can be structured where certain responsibilities are shared between the participants and other responsibilities are solely the responsibility of one of the participants.
Scope of Pronouncement of a Collaborative Arrangement [EITF 07-1]
Under EITF 07-1, an activity (referred to as an “endeavor”) that is the subject of a joint operating arrangement is characterized as a collaborative arrangement within the scope of the pronouncement if:
- The endeavor involves two or more parties
- Both (all) of the parties are:  Active participants in the endeavor; and  Exposed to significant risks and rewards that depend on the endeavor’s commercial success.
- The endeavor is not primarily conducted through a separate legal entity created for it.
In evaluating whether a participant is active with respect to an endeavor, management is to consider the arrangement’s specific facts and circumstances.
Examples of involvement that could constitute active participation include, but are not limited to:
- Directing and executing the activities of the endeavor;
- Participating on a steering committee or other oversight or governance body;
- Possessing a legal or contractual right to the intellectual property that underlies the endeavor.
Note: Solely providing financial resources to an endeavor would not constitute an active level of involvement for the purposes EITF 07-1.
Significant Risks and Rewards
Management of a participant is to exercise its best judgment in evaluating whether the participant is exposed to significant risks and entitled to significant rewards. Consideration is to be given to the terms and conditions of the arrangement and the facts and circumstances surrounding it including:
- The stage of the endeavor’s life cycle at which the participant is commencing its involvement
- Management’s expectations regarding the duration and extent of its financial participation in relation to the total expected duration and total expected value of the endeavor.
Examples of terms and conditions of an arrangement that may indicate that a participant is not exposed to significant risks or entitled to significant rewards include:
- Market rates are paid for services provided by the participant
- Ability of a participant to exit the arrangement without cause and recover all or most of its cumulative economic participation through the exit date
- Limits on the rewards that a participant is entitled to receive
- Allocation of initial profits from the endeavor to only one participant
Frequently, a collaborative arrangement will involve the license of intellectual property with the participants to the arrangement exchanging consideration with respect to the license at the arrangement’s inception. The existence of terms of this nature are not necessarily indicative of the participants not being exposed to significant risks or entitled to significant rewards.
Timing of Determination or Re-determination
A participant may become involved in a collaborative arrangement at any time during the life cycle of the endeavor. From the perspective of a participant, determination of whether an endeavor is a collaborative arrangement is to be made at the inception of the arrangement or when the participant initially becomes involved in the arrangement based on the facts and circumstances existing at that time. A participant is to reevaluate whether the arrangement continues to qualify as a collaborative arrangement any time there is a change in a participant’s role in the arrangement or a change in a participant’s exposure to risks or entitlement to rewards from the arrangement.
Accounting For Transactions Conducted In A Separate Legal Entity
Any transactions associated with the endeavor that are conducted in a separate legal entity are to be accounted for under other applicable accounting pronouncements such as:
- Consolidation of voting interest entities
- Consolidation of variable interest entities
- Joint ventures
Accounting For Transactions with Unrelated Third Parties
A participant in a collaborative arrangement is to recognize revenue earned and costs incurred in transactions with third parties (parties that are not participants to the collaborative arrangement) in its income statement based on whether the participant is serving as a principal or an agent in the transaction under ASC 605-45:
- If the transacting participant is considered a principal in the transaction, the revenues and costs are recorded gross.
- If the transacting participant is considered an agent in the transaction, the revenues and costs are recorded net.
Under no circumstances is a participant in a collaborative arrangement permitted to use the equity method of accounting to account for its activities associated with the collaborative arrangement.
ASC 605-45 does not provide a “bright-line” test that definitively would characterize the role of a participant in a transaction. Rather, it provides a series of indicators of gross reporting and a series of indicators of net reporting, the purpose of which is to enable management to analyze the facts and circumstances associated with the transaction to make a well-reasoned determination.
Indicators of Gross Reporting (Principals)
- Participant is primary obligor. Under ASC 605-45, this is considered to be a “strong indicator” of the participant’s role in the transaction.
- Participant has authority, within reasonable limits, to establish price. Even when subject to reasonable, pre-established economic constraints, if the participant has the authority to negotiate price with the customer, this may indicate that the participant possesses risks and rewards of a principal to the transaction.
- Participant involvement in determining specifications. If the participant has the authority to determine the nature, type, characteristics, or specifications of the products and/or services ordered by the customer, this may be indicative of the participant having primary responsibility for fulfillment. For the purposes of analyzing the applicability of this indicator, the evaluator considers whether the participant makes physical alterations to the product or performs services that add value sufficient to increase the selling price to the customer.
- Participant performance. The participant changes the product or performs part of the service.
- Participant discretion in supplier selection.
- Participant exposed to inventory risks. The participant bears inventory risk in one or both of the following manners: [a] General inventory risk either before the customer places the order or upon the return of the inventory by the customer; [b] Specific risk of physical inventory loss after the customer places the order or during shipping of the inventory; and [c] Participant bears credit risk.
Indicators of Net Reporting (Agents)
- Participant in not the primary obligor. The supplier of the goods or services, not the participant, is the primary obligor in the transaction.
- Participant earnings are fixed. The amount the participant earns is fixed.
- Participant is not exposed to credit risk. The supplier and not the participant bears credit risk in connection with the transaction.
Accounting For Transactions between Participants
In evaluating the income statement characterization of transactions between participants to a collaborative arrangement, management is to consider:
- The nature of the arrangement
- The contractual terms of the arrangement
- The nature of the participant’s business operations
- Whether the transactions are included in the scope of other authoritative GAAP literature on income statement classification, either directly or by analogy
If no authoritative GAAP is identified that is relevant directly or by analogy, management is to elect a reasonable and rational accounting policy to be consistently applied to all such similar transactions.
Disclosure of Collaborative Arrangement
The following disclosures apply to the entire endeavor characterized as a collaborative arrangement, even if a portion of the endeavor is being conducted through the use of a legal entity.
A participant to a collaborative arrangement is required to disclose in the initial interim or annual period of its participation in the arrangement and all annual periods thereafter:
- Its accounting policy for collaborative arrangements,
- Information regarding the nature and purpose of the collaborative arrangements in which it participates,
- Its rights and obligations under the collaborative arrangements,
- For each period for which an income statement is presented, the income statement classification and amounts attributable to transactions arising from the collaborative arrangement between the participants.
Note: Disclosures are to be made separately for each individually significant collaborative arrangement in which the reporting entity participates.
Curiously, the standard did not require disclosure of the nature, classification, and amounts of revenues and costs recognized in the income statement from transactions between the participant and third parties. The authors believe that management should voluntarily include such disclosures to supplement the disclosures listed above, as that information is exceedingly relevant to users of the financial statements to enable them to assess the relative significance of the arrangements to the reporting entity’s financial performance.
EITF 07-1 is to be adopted through retrospective application to all prior periods presented for all collaborative arrangements existing as of the effective date of the consensus. If it is not practical to retrospectively apply the consensus, management is to disclose both the reasons why reclassifications were not made and the effect of the reclassification on the current period in accordance with ASC 250-10-45.
The determination of whether retrospective application is practical is to be made on an arrangement-by-arrangement basis. In the period of initial application, a participant is to disclose:
- A description of the prior period information that has been retrospectively adjusted, if applicable; and
- The effect of the change on revenue, operating expenses, and any other affected financial statement line items.
Matters for Which Guidance Is Not Provided
Although the consensus is quite complex, the EITF took great pains to point out several matters that are not covered by the consensus and that require careful scrutiny of other authoritative literature and the exercise of professional judgment. The scope of 07-1 specifically excludes:
. Arrangements for which the accounting treatment is addressed by other authoritative literature,
. Guidance regarding matters such as:
- Determining the appropriate units of accounting
- Determining the appropriate recognition requirements for a given unit of accounting,
- The timing of when recognition criteria are considered to have been met.