Quality of Earnings in a Company With No Earnings

A quality-of-earnings review of a pre-revenue therapeutics or diagnostics company cannot normalize an EBITDA that does not exist, so its scope has to be rebuilt around what the company spends, what it has been promised, and what it already owes. Four workstreams replace the standard ones: burn quality, grant accounting, milestone and collaboration recognition under ASC 606 and ASC 808, and clinical-cost accruals.

01The Scope Substitution

The standard quality-of-earnings engagement is built for a company that earns money. It bridges reported EBITDA to an adjusted figure, sets a normalized working-capital peg, and lists the debt-like items a buyer should deduct from price. In a clinical-stage company each of those outputs is either empty or misleading. Adjusted EBITDA becomes a larger loss with a different set of adjustments. A working-capital peg means little when the largest current liability is an estimate of clinical services already received and not yet invoiced.

The questions a growth equity investor needs answered are different in kind. Is the reported spending complete? Will the non-dilutive income survive scrutiny? Is collaboration revenue revenue at all? How much cash is already committed? Each question has a governing standard, and each standard leaves room for judgment that moves the numbers a buyer relies on.

02Burn Quality

Research and development costs within Subtopic 730-10 are expensed as incurred, a rule that dates to FASB Statement No. 2 in 1974. The income statement of a pre-revenue company therefore sits close to its cash spend, but it is never identical to it. Three sources create the gap. Nonrefundable advance payments to research vendors are deferred and expensed as the services are rendered under ASC 730-20-25-13. Services already received are accrued before they are invoiced. Equipment and other acquired assets with an alternative future use are capitalized and depreciated into research expense over time.

The first test is a monthly bridge from reported operating expense to cash outflow, by program. A company running two clinical programs and a platform effort has three burn rates, and the one that matters for valuation is usually the lead program's cost to its next data readout. The same question reaches the limited partner: a general partner that holds the company also reports its value, and the accounting and valuation section of the ILPA due diligence questionnaire is where limited partners ask how that value was reached.

The second test looks for burn that has been managed for the reporting date. Stretched payables, deferred bonuses, paused enrollment, a postponed manufacturing campaign and a hiring freeze all lower the reported number without lowering the cost of completing the plan. Payables aging, vendor statements and the enrollment curve against the protocol plan show each deferral, which is restated into the period the plan requires it.

The third test separates gross burn from net burn. Topic 832 permits a grant related to income to be deducted from the related expense, and paragraph 808-10-45-3 leaves the presentation of collaboration payments outside other literature to analogy or a consistently applied policy election, under which a partner's cost-sharing payment can be shown as a reduction of research expense. Both are acceptable presentations, and both make research look cheaper than it is. The review restates research spend gross, then shows each offset as its own line with its end date, because a grant that expires in nine months is not part of the run rate.

03Milestone and Collaboration Revenue

Topic 606, issued as ASU 2014-09, treats a payment contingent on a future event as variable consideration, and paragraph 606-10-32-6 names a performance bonus on achievement of a specified milestone as its example. The entity estimates the amount by expected value or by most likely amount under 606-10-32-8; the most likely amount may be appropriate where the contract has only two possible outcomes, which describes most development milestones. The estimate is then subject to the constraint in 606-10-32-11: variable consideration enters the transaction price only to the extent it is probable that a significant reversal of cumulative revenue will not occur when the uncertainty resolves.

Paragraph 606-10-32-12 lists the factors that raise the risk of reversal, among them consideration highly susceptible to factors outside the entity's influence, including the judgment or actions of third parties; uncertainty not expected to resolve for a long period; and limited experience with similar contracts. A milestone payable on regulatory approval turns on a regulator's judgment, so it is ordinarily excluded from the transaction price until the approval occurs. The estimate is updated at each reporting date under 606-10-32-14. The review asks what evidence supported each milestone's inclusion on the date it entered the transaction price.

License terms decide the timing of the largest single number in most biotech partnerships, the upfront payment. Under the licensing amendments in ASU 2016-10, a right to use functional intellectual property is satisfied at a point in time (606-10-55-58B), and no revenue is recognized before the licensee has the intellectual property and the period of use has begun (606-10-55-58C). Example 56 in that update shows the other path: a drug-patent license bundled with manufacturing that no other party can provide is not distinct, and the two are a single performance obligation. Distinctness from the licensor's ongoing research services decides whether an upfront payment is revenue on day one or deferred over years.

A deferred upfront payment deserves particular attention in a transaction. The cash has typically been spent, while the obligation to perform the remaining research services passes to the buyer with the company. The review treats the cost to fulfill that obligation as a debt-like item and does not let the contract liability's book value stand in for it. Sales-based royalties follow their own rule: under 606-10-55-65 they are recognized only when the later of the underlying sale or the satisfaction of the related performance obligation occurs, and 606-10-55-65A extends that treatment to royalties where a license is the predominant item.

Topic 808 governs arrangements in which the parties actively participate in a joint operating activity and are exposed to significant risks and rewards that depend on its commercial success. ASU 2018-18 settled its interaction with Topic 606.

A collaborative arrangement is partially within Topic 606 when a distinct unit of account, identified under 606-10-25-19 through 25-22, is with a customer (808-10-15-5B). Parts outside Topic 606 are accounted for by analogy or by a reasonable, rational and consistently applied policy election (808-10-15-5C and 808-10-45-3). An entity is precluded from presenting collaborative transactions together with revenue from contracts with customers unless Topic 606 applies to that unit of account. The update took effect for public business entities for fiscal years beginning after December 15, 2019, and for all other entities for fiscal years beginning after December 15, 2020.

The consequence for diligence is direct. A line labeled collaboration revenue may be cost-sharing reimbursement from a partner that is not a customer, and it does not belong in any revenue multiple. The review separates customer revenue, collaboration income and reimbursements before any valuation work begins. A diagnostics company with early test volume run in its own laboratory raises a related issue: where the company expects to accept less than the billed price, paragraph 606-10-32-7 treats the expected shortfall as an implicit price concession, which is variable consideration. Collections by payer and by test code over the trailing period, compared with the revenue recorded, show whether that estimate is credible.

04Grant and Funded-Research Accounting

Until December 2025, US GAAP had no recognition model for a government grant to a business entity. ASU 2025-10 records that practice analogized to IAS 20 or, less commonly, to Topic 450 and Subtopic 958-605, with resulting diversity. ASU 2021-10, issued in November 2021, added annual disclosures for business entities applying a grant or contribution model by analogy: the nature of the transactions and the accounting policy, the affected line items and amounts, and significant terms and conditions, including commitments and contingencies. Those disclosures are the review's starting inventory.

ASU 2025-10, issued in December 2025, creates the first recognition model in Topic 832. A government grant is recognized only when it is probable both that the entity will comply with its conditions and that the grant will be received (832-10-25-1), and receipt of the cash is not by itself conclusive evidence of compliance (832-10-25-2). A grant related to income is recognized in earnings on a systematic and rational basis over the periods in which the related costs are expensed (832-10-25-9) and is presented either as other income or as a deduction from the related expense (832-10-45-3). The update is not yet mandatory for any company, and early adoption is permitted.

Example 2 in the update is the pre-revenue case exactly: a cost-reimbursement grant for the research and development of a new drug, recognized as the qualifying costs are incurred, with no receivable until they are (832-10-55-12 and 55-13). If a grant becomes repayable, the repayment is applied first against any unamortized deferred income and the excess goes to earnings (832-10-35-1). The review therefore tests compliance with each award's conditions, the documentation behind every reimbursement claim, and any repayment trigger, because recognized grant income carries that exposure until the conditions are settled.

Scope is the first question. The grant definition excludes exchange transactions, so a government contract under which an agency procures development work is not a grant; the Board noted that a transaction with a government may fall within another Topic, such as Subtopic 912-730 for federal research and development contractors. Topic 832 also excludes income tax credits within Topic 740, the benefit of below-market loans and government guarantees (832-10-15-4A), along with contributions from nongovernmental sources within Subtopic 958-605 (832-10-55-5). A disease foundation's award to a company sits outside Topic 832 entirely, and its terms decide whether it is a contribution, a contract with a customer or a financing.

Money from investors or partners earmarked for research falls under Subtopic 730-20, which asks whether the recipient has an obligation to repay others or to perform research for others. Paragraph 730-20-25-6 presumes repayment when, among other conditions, the entity has signaled an intent to repay regardless of outcome, would suffer a severe economic penalty by not repaying, or has a significant related-party relationship with the funder. The SEC staff's view in 730-20-S99-1 is that such a relationship exists when related parties own 10 percent or more of the funding entity.

The liability stands even when repayment would come in securities (730-20-25-3), and in the SEC staff's view an apparent inability to repay in cash does not show that the funders accepted the research risk. Only a substantive transfer of financial risk, with repayment depending solely on the research producing future economic benefit, supports treatment as a contract to perform research for others under 730-20-25-8. A funded-research arrangement booked as income that fails this test is a liability, and the review moves it into net debt.

05Clinical-Cost Accruals and Committed Spend

The cost of contract services is an element of research and development cost under ASC 730-10-25-2(d), and the cost of services performed by others is recorded in the period the services are provided, which in practice requires periodic progress reports from the contract research organization and the sites. Advance payments deferred under 730-20-25-13 are reassessed periodically to determine whether it remains probable that the goods or services will be provided, and an advance for services the entity no longer expects to receive is expensed immediately.

The accrual is an estimate built from drivers: patients screened and enrolled, visits completed, sites activated, and pass-through costs such as investigator fees, laboratory kits and imaging. The review rebuilds it independently from those drivers and from the contracts' payment schedules, compares the result with the research organization's own unbilled estimate, and traces invoices received after the balance-sheet date back to the period in which the work was performed. A company whose accrual has been revised upward quarter after quarter has been reporting a lower burn than it incurred.

An understated accrual does two kinds of damage. It flatters burn and lengthens apparent runway, and in a transaction it is an unrecorded liability that passes to the buyer at closing. The review sets the clinical accrual at the rebuilt amount for the net-debt schedule, then adds the obligations that never reach the balance sheet: noncancelable portions of research and manufacturing contracts, site close-out and patient follow-up costs if a program is stopped, and cancellation fees in vendor agreements.

The runway figure that results is the central number of the report: available cash divided by normalized gross burn, measured against the date of the next value-inflection event, with each grant and milestone inflow shown separately and excluded from the base case. A pre-revenue company has no earnings to judge, but its spending, its promises from partners and governments, and its obligations can each be tested with the rigor a buyer applies to revenue.

06Frequently asked questions

Is a quality-of-earnings review useful for a company with no revenue?

Yes, once its scope is rebuilt. In place of adjusted EBITDA, the review tests burn quality, grant accounting, milestone and collaboration recognition, and clinical-cost accruals, and it produces a normalized burn, a net-debt schedule that includes committed spend, and a runway measured against the next value-inflection event.

How are development and regulatory milestones recognized under ASC 606?

A milestone is variable consideration. It enters the transaction price only to the extent it is probable that a significant reversal of cumulative revenue will not occur when the uncertainty resolves (ASC 606-10-32-11). Because a regulatory-approval milestone depends on the judgment of a third party, it is ordinarily excluded until approval, and the assessment is updated at every reporting date.

How does a business entity account for a government research grant?

Business entities have historically applied a grant model by analogy, most often IAS 20, with disclosures required by ASU 2021-10. ASU 2025-10 now establishes a model in Topic 832: recognize the grant when compliance and receipt are both probable, and recognize a grant related to income over the periods in which the costs it compensates are expensed, presented as other income or as a reduction of the related expense.

Nothing in this piece is investment, legal, tax or accounting advice, and nothing in it is an offer to sell or a solicitation of an offer to buy any security.