On January 1, 2018, Pharmagen (Pharma), a pharmaceutical company entered into a funding agreement (Agreement) with a third-party private equity investor (PEI). The PEI has no prior relationship or business operations related to Pharma.

As part of the Agreement, Pharma will receive funding from the PEI (up to a maximum of $500 million) for research and development (R&D) costs incurred by Pharma for the development of a potential new drug (Drug X). Prior to contracting with the PEI, Pharma had already started developing Drug X as a self-funded R&D project. Therefore, the Agreement between Pharma and the PEI created an arrangement where the PEI would provide financial support for the continued development of Drug X. The funding received by Pharma is to be used solely for the development of Drug X and may not be used for any other purposes. Amounts received by Pharma are non-refundable and Pharma is not obligated under the Agreement to successfully complete the development of Drug X. Rather, Pharma will receive incremental funding from the PEI as long as Pharma is demonstrating progress towards the development of Drug X. In other words, Pharma is operating under a best efforts arrangement and has no additional performance obligations to the PEI after it receives the funding. Pharma has estimated that it will incur a total of $1 billion of R&D costs over a period of three years associated with its development project. The Agreement states that Pharma will retain all the intellectual property rights to Drug X once it is developed.

In return for funding R&D activities for Drug X, the PEI is entitled to receive future royalties from Pharma. Specifically, the PEI will receive (1) royalties associated with future revenues of Drug X (if and when Drug X has been successfully developed, approved by a regulatory agency, and commercialized for sale) and (2) future royalties associated with an existing drug (Drug Y) for a defined period of time. Drug Y has already received regulatory approval and is commercialized for sale. Pharma has estimated that if the development of Drug X is successful, the amount of royalties that will be paid to the PEI will total $400 million. Royalties associated with Drug Y are estimated to be $250 million.

Required:

Determine how Pharma should account for the R&D arrangement described above. Specifically, answer the following questions regarding the arrangement:

1. Should Pharma record a liability for the future royalties it owes to the PEI? Why or why not? If a liability should be recorded, what amounts should be included in this liability (and why)?
2. Should Pharma record the costs it incurs while performing R&D activities associated with Drug X as R&D expense? Why or why not?

For requirements 1 and 2 above, be sure to discuss the alternative accounting treatments that Pharma should consider (and why each may or may not be appropriate), as well as your recommendation of the best accounting treatment, given the circumstances described in the case. Be sure to support your discussion with guidance from the FASB Codification and any other sources you see fit. Refer to the Research Case Instructions posted to WebCampus for further details on writing up your case (including page length). The case is due (via WebCampus submission) by 11:59pm on December1^st.