IFRS 3 Royalty arrangements as contingent considerations

IFRS 3 Royalty arrangements as contingent considerations – Companies in the extractive industry often acquire properties that are subject to a royalty payable to the seller of such property. Are the royalty arrangements contingent consideration?

A royalty payable to the seller of the property in a business combination is almost always contingent consideration. However, arrangements may be described as royalties that are actually the retention of a working interest. A retained working interest may well be accounted for as an undivided interest. IFRS 3 Royalty arrangements as contingent considerations

Management needs to exercise judgement as to whether an arrangement is a royalty or a retained working interest. This has represented a change in practice for many entities in the extractive industry that may have treated vendor-type royalties as period costs prior to the adoption of IFRS 3 (2008). Any royalties, subsequent payments or transfer of shares to the seller should be scrutinised to determine if these are contingent consideration. IFRS 3 Royalty arrangements as contingent considerations

The terms of these types of arrangement in the extractive industry vary widely. Some legal frameworks do not allow undivided interests in the title to a property to be held. Royalty arrangements are the only way that the market participants can share in undivided interests. IFRS 3 Royalty arrangements as contingent considerations

Some of the key terms which vary between royalty arrangements are: Perpetual versus time limited royalties; Royalties subject to a volumetric cap, floor or collar; Royalties that are based on gross sales or payable net of extraction costs; Royalties that are at a fixed price or variable price; Royalties settled in physical product, in cash at the spot rate, or in cash at a fixed price subject to a cap, floor or collar; and Royalties subject to monetary caps or floors in aggregate. IFRS 3 Royalty arrangements as contingent considerations

Each of these terms can have an impact on the substance of the royalty arrangement. The arrangement is likely to be contingent consideration if the acquirer has taken control of the entire property or business and cannot avoid making future payments to the seller.

Some arrangements might share attributes of ownership with the previous owners, such as the following risks: Reserve risk – the risk that physical reserves are less than expected; Extraction risk – the risk that extraction costs are higher than expected; and Price risk – the risk relating to proceeds from selling the extracted minerals.

It becomes less clear whether contingent consideration or a retained working interest exists when all the risks of ownership are shared with the previous owners. However, retained interests with capped volume, fixed price or for a limited duration are almost certainly contingent consideration. IFRS 3 Royalty arrangements as contingent considerations

Example – contingent consideration royalties

Entity A agrees to purchase a gold producing property from Entity B for C50m in cash plus an additional payment at a fixed per-ounce price of gold produced from the property for the 2 years following the acquisition. The additional payment contains a cap of 6,000 ounces and a floor of 5,000 ounces. The mine plan indicates production over the 2-year period between 4,500 t0 6,500 ounces.

Is the royalty arrangement contingent consideration?

Simplifying assumption(s): The arrangement is not linked to providing services. The fair value of the payment stream is estimated at C10m. The property meets the definition of a business under IFRS 3. This is not a joint arrangement.

Solution

The buyer has acquired 100% of the property, subject to a royalty to pay part of the volume of gold produced. The royalty is not a retention of a working interest because the seller has limited price, reserve and extraction risk. The arrangement is contingent consideration that will be settled based on a formula that is volume based.

The following journal entry is recorded on the acquisition date for the consideration:

Net assets and goodwil

60

Cash

50

Contingent consideration

10

To record Entity A’s initial purchase of property

Future changes in the fair value of the contingent consideration based on changes in the expected production are recognised in the income statement each reporting period until the arrangement is settled.

Companies in the pharmaceutical industry often acquire smaller start-ups or biotech entities. The acquisition may include a royalty payment determined in future periods, based on a percentage of drug sales from the acquired intellectual property. Are the royalty arrangements contingent consideration?

Intellectual property (IP) in the form of licences is common within the pharmaceutical industry. The IP is transferred between deal-making partners in order to pursue research, development and/or commercialisation of technology, compounds or other licensed products. These strategic alliances are established through contracts involving the transfer of legal rights and may give rise to out-licensing deals. Out-licensing involves the sale or granting of exclusive or non-exclusive access rights by the party who owns or controls the IP (licensor) to an alliance partner (licensee).

A typical out-licensing deal structure includes many contingent payments such as development milestones (for example, upon approval by regulatory agency), commercial milestones (for example, upon reach a certain sales level) and royalties (for example, based on the sale of products that use its IP − usually expressed as a percentage of the sales).

Amounts due to the seller of a business in the form of a milestone payment or royalty are part of the consideration transferred for the business acquired. The amount of the consideration that will be contingent on a milestone or future sales should be measured at fair value at the acquisition date, with subsequent changes in the estimated out flows measured through the income statement.

Not all royalties are contingent consideration. Licensed intellectual property may represent an executory contract. Executory contracts are contracts under which neither party has performed any of its obligations or both parties have partially performed their obligations to an equal extent (IAS 37 3). IFRS 3 Royalty arrangements as contingent considerations

An executory contract for a market-rate royalty arrangement could be asserted to be a separate transaction and accounted for on a ‘pay as you go’ basis. This assertion requires a continuing involvement of the licensor, such as continuing to provide research or development services each time a sale is made by the licensee. Lump sum payments on sales milestones should be evaluated to determine if the seller has any further obligations; the arrangement might therefore be classified as an executory contract.

Most royalty arrangements seem to be contingent consideration and are treated in a way similar to development milestones, absent this continuing involvement. The determination of whether a contract is executory is an area of judgement. IFRS 3 Royalty arrangements as contingent considerations

Example – Accounting for royalties in the pharmaceutics industry

Pharma Co acquires Biotech Co for C200m cash, plus a percentage of cumulative sales from any drug based on Biotech Co’s main IP comprised as follows:

  • 5% sales up to C100m; and
  • 10% of sales > C100m.

The acquisition includes Biotech Co’s IP. Pharma Co estimates actual sales of the drug will be C200m if successfully approved and there is a 70% probability of successful approval at the acquisition date. By the end of the year 1 after the acquisition date, management believes that actual sales of the drug will be C300m if successfully approved, and that there is a 90% chance of successful approval.

Is the royalty arrangement contingent consideration?

Simplifying assumption(s): Biotech Co meets the definition of a business under IFRS 3. The royalty rates are market value royalty rates for the industry. Ignore the time value of money.

Solution

The sellers of Biotech Co have no further obligation to deliver further services. No licence or executory contract is therefore involved.

The royalty arrangement is contingent consideration that should be measured at fair value as a component of the consideration transferred to acquire a business.

At the acquisition date:

Sales forecast (C millions)

Royalty rate

Royalty payment

100

5.00%

5

100

10.00%

10

Total

15 (a)

Probability

70.00% (b)

Fair value

10.5 = (a) x (b)

Journal entry at acquisition:

Net assets and goodwill

210.5

Cash

200.0

Contingent consideration

10.5

At year 1 after the acquisition date:

Sales forecast (C millions)

Royalty rate

Royalty payment

100

5.00%

5

200

10.00%

20

Total

25 (a)

Probability

90.00% (b)

Fair value

22.5 = (a) x (b)

The increase from the acquisition date is 12.0, which result in the following journal entry:

Income statement

12.0

Contingent consideration

12.0

To record the increase in the fair value of the royalty payment.

Future changes in the fair value of the contingent consideration based on expectations of sales continue to be recognised in the income statement at each reporting period.

IFRS 3 Royalty arrangements as contingent considerations

IFRS 3 Royalty arrangements as contingent considerations IFRS 3 Royalty arrangements as contingent considerations IFRS 3 Royalty arrangements as contingent considerations

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