IFRS 3 Royalty arrangements as contingent considerations – Best Fine Read

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? IFRS 3 Royalty arrangements

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

IFRS 3 provides guidance for determining whether the buyer has acquired a business or an asset (or group of assets). Whether the purchase or license of intellectual property meets the accounting definition of a business is a hot topic, and in many cases arrangements that on the surface appear to convey only assets include other elements that, when combined, may meet the accounting definition of a business (and therefor are accounted for as a business combination). Because many acquisitions or licenses or royalty payments to the seller/licensor,the accounting and valuation of those contingent payments is often complex.

Payments related to these contingent obligations are often triggered by regulatory approval of in-process research and development (IPR&D) projects, or based on future performance measures, such as a percentage of sales.

The buyer should classify contingent consideration as a liability, an asset, or equity depending on its terms. All contingent consideration arrangements are initially measured at fair value on the acquisition date. Contingent consideration that is classified as a liability or asset is remeasured to fair value at each reporting date, with changes included in the income statement in the post-combination period until the uncertainty is resolved. Contingent consideration that is classified as equity is not remeasured, and is accounted for within equity upon settlement.

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

Compensation

The selling shareholders may become employees of the combined entity. It is important to determine whether any portion of the future royalty payments represents compensation to those selling shareholders/employees. When there is a requirement for continuing employment in order to be entitled to the future royalty payments, the cost of the arrangement is reflected as compensation expense in the buyer’s financial statements in the post-combination period.

Something else -   Contingent consideration

When there is no requirement for continuing employment, a buyer must consider a number of indicators to determine whether the future royalty payments represent part of the purchase price or are separate transactions designed to compensate employees. These indicators include whether all selling shareholders receive the same per share payment regardless of employment, and whether employee compensation other than the contingent payments is at reasonable levels. If the arrangement is deemed to be compensation, the arrangement would not be contingent consideration under IFRS 3.

Extractive industry royalty arrangements

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 arrangementsIFRS 3 Royalty arrangements

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

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. IFRS 3 Royalty arrangements

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. IFRS 3 Royalty arrangements

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

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 goodwill

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.

Royalty arrangement as contingent arrangement

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-IFRS 3 Royalty arrangementsmaking 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).

Something else -   Business combination

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

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.

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; andIFRS 3 Royalty arrangements
  • 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

Something else -   M and A

IFRS 3 Royalty arrangements IFRS 3 Royalty arrangements IFRS 3 Royalty arrangements IFRS 3 Royalty arrangements IFRS 3 Royalty arrangements

Scenario: Acquisition of a business that includes future royalties payable to a seller

Background

Company A is a large pharmaceutical business that owns several compounds, including Compound X. Compound X recently received regulatory approval and Company A has contracted with a third party to manufacture Compound X. In addition, Company A has other contracts to purchase raw materials, has specific employees responsible for regulatory issues, and a dedicated sales force related to Compound X.

Company B enters into an agreement to acquire Compound X from Company A. The acquisition of Compound X includes transfer of the third-party manufacturing agreement and existing contracts for raw materials, and the fixed assets specific to Compound X, as well as certain employees dedicated to sales of Compound X. Company B determines that the set of acquired assets includes inputs, processes, and outputs and therefore concludes that the purchase of Company X constitutes a business.

Company B makes an up-front cash payment to Company A. Company B also agrees to pay Company A future royalties of 5% of the net sales of Compound X for the next three years.

How should Company B account for the royalty payments due to Company A?

Analysis –IFRS and US GAAP

Because it is the acquisition of a business, the future royalty payments to Company A (the seller) meet the definition of contingent
consideration under both US GAAP and IFRS. Company B would record a liability equal to the fair value of the expected future royalty payments on the date of acquisition.

Company B would need to consider the key inputs of the arrangement and market participant assumptions when determining the fair value of the contingent consideration, including estimates of the amount, timing, and likelihood of expected royalties. The estimated fair value of the future royalty payments would be marked to market through earnings until the contingency is resolved.

Note that the valuation of acquired Compound X, if determined using a discounted cash flow model, would need to exclude any estimated future cash outflows already accrued as contingent consideration.

 

Also read – IFRS 3 Royalty arrangements

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Something else -   Accounting treatment acquisition of a business or assets

IFRS 3 Royalty arrangements

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