Benchmark study of the application in - PwCBenchmark study of the application in Europe of IFRS in the Life Sciences Sector 5 This benchmark study provides insight into the impact

benchmark study of the application of IFRS in the Life Sciences Sector.*

Benchmark study of the application in Europe of IFRS in the Life Sciences Sector*

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Contents

Introduction 4

Executive summary 6

Benchmark of key IFRS topics for the Life Sciences sector 9First-time adoption of IFRS 9Share-based payment 14Research and development expenditure 19Business combinations including goodwill and other intangible assets 24Revenue recognition 27Deferred tax 34

Other adjustments and accounting areas 38

Making it more than just about the numbers – embedding IFRS 39

Appendix A: Overview of companies included in the benchmark 40

Your contacts 41

Legal Disclaimer 42

4 PricewaterhouseCoopers

Introduction

As from 1 January 2005 most listed companies in Europe have adopted International Financial Reporting Standards (“IFRS”). However, the transition to and reporting under IFRS continues to be a challenge for the Life Sciences sector to address. This is specifically true because at this moment, early 2007, the window for Initial Public Offerings of Life Sciences companies seems to have opened up again and as a result several companies are currently preparing themselves for such an IPO, including the necessary transition to IFRS.

The transition to IFRS is more than just an accounting issue. IFRS covers everything from mergers and acquisitions to leasing, revenue recognition, and accounting for employee benefits. It requires substantial changes, including new accounting policies, and more disclosure than before. Transition to IFRS will in most cases impact the reported profitability of the businesses themselves, but will also influence contract negotiations and other operational matters.

Life Sciences companies are no exception. IFRS substantially influences this sector, not only in terms of practical transitional issues, but also in respect to reportable earnings, net asset value, the level of gearing, and return on capital employed.

In this IFRS benchmark study we have analysed the financial statements of 20 European Life Sciences companies that have prepared their financial statements for 2005 in accordance with IFRS (an overview of the companies is included in appendix A). Of the 20 companies analysed, 13 companies were first-time adopters of IFRS as from 1 January 2005; 2 companies are based in the UK and the other 18 on the European main land (Switzerland, Sweden, The Netherlands, Belgium, Germany and France). When we refer to “companies” in this study, we mean their financial statements.

We have summarised the impact of the transition to IFRS and considered the take up by companies of the exemptions that were available to them under IFRS 1 “First time adoption of International Accounting Standards”. Next we assessed the impact IFRS has on the financial reporting of Life Sciences companies by performing a benchmark of certain key accounting topics for companies in the sector. Where applicable, we have also included observations from a survey in which PricewaterhouseCoopers in the UK analysed the first IFRS financial statements of 25 companies in the techMARK mediscience index. The findings from the UK analysis were published in January 2007 in the publication “IFRS and its impact on Financial Reporting for the Life Sciences Sector”.

5Benchmark study of the application in Europe of IFRS in the Life Sciences Sector

This benchmark study provides insight into the impact of IFRS for Life Sciences companies but as with any form of empirical analysis, there are inherent limitations. This document does not seek to cover all of the accounting rules, but focuses instead on selected key topics and offers guidance. Each company will ultimately need to consider its own circumstances and apply the IFRS rules accordingly.

PricewaterhouseCoopers continues to lead the debate within this sector and is committed to helping companies maximise the benefits of IFRS and improve the quality of their IFRS reports. We hope you find this document helpful and look forward to discussing your comments and questions.

Arwin van der Linden Alexander SpekLeader of the Dutch Partner PwC Accounting Life Sciences Practice Advisory Services


Executive summary

IntroductionThis document serves as an IFRS benchmarking tool for companies in the Life Sciences industry in respect of the following key accounting topics:

First-time adoption of IFRS Share-based paymentResearch and development expenditureBusiness combinations including goodwill and other intangible assetsRevenue recognitionDeferred taxes

We have analysed the financial statements of 20 European Life Sciences companies that have prepared their financial statements for 2005 in accordance with IFRS. The home countries of these companies are shown in the diagram below. Of the 20 companies analysed, 13 companies were first-time adopters of IFRS as from 1 January 2005, while 7 companies already produced accounts under IFRS prior to 2005.

First-time adoption of IFRSAs illustrated in the diagram below, the accounting standards that caused the most adjustments to their previous accounting standards for the 13 first-time adopters were:

IFRS 2 “Share-based Payment” IFRS 3 “Business Combinations” IAS 2 “Inventories” IAS 18 “Revenue” IAS 19 “Employee Benefits” IAS 37 “Provisions, Contingent Liabilities and Contingent Assets” IAS 38 “Intangible Assets” IAS 39/32 “Financial Instruments: Recognition and Measurement/Presentation”

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The Netherlands (4) 20%

Belgium (6) 30%

Germany (3) 15%

Switzerland (3) 15%

France (1) 5%

Sweden (1) 5%

The UK (2) 10%


IFRS 2, IFRS 3, IAS 38 and IAS 18 will be discussed later, as well as the IFRS 1 exemptions from full retrospective application of IFRS as applied by the Life Sciences companies included in our survey.

Share-based paymentWe found that 18 of the 20 companies (90%) have used share-based payments to compensate management and employees. Furthermore, 9 companies (45%) have also recorded share-based payments transactions with non-employees such as advisors and consultants.

Research and development expenditureUnder IFRS, development costs must be capitalised when the future technical feasibility and economic benefit of an asset can be demonstrated. Due to the high levels of research and development expenditure in the Life Sciences sector, this requirement is important for companies within the sector. We found that 2 of the 20 companies (10%) have capitalised internal development expenses. This observation, however, could be explained by the fact that many of the analysed Life Sciences companies still are in an early stage of their drug development process.

Business combinations including goodwill and other intangible assetsUnder IFRS 3 “Business Combinations” and IAS 36 “Impairment of Assets”, goodwill is no longer amortised through the profit and loss account but is subject to an annual impairment test. We found that 5 of the 13 first-time adopters of IFRS (38%) have made adjustments for non-amortisation of goodwill following the adoption of IFRS.

Revenue recognitionIAS 18 “Revenue” is not a standard with prescriptive rules and therefore the practical application requires judgement which may give rise to differences with previous accounting standards. Of the 13 first-time adopters of IFRS, 3 companies (23%) reported differences with regard to revenue recognition.

02468

1012

IFRS2

IFRS3

IAS19

IAS38

IAS2

IAS18

IAS37

IAS32/39


A company should disclose the accounting policy and the amount of revenue recognised during the period for each significant revenue category. This seems to be an area where an industry view should be formed as our survey identified a diverse practice among the companies analysed.

Deferred taxesOf the 20 companies, 19 companies (95%) disclosed unused tax losses, mainly relating to losses incurred as a result of research activities. Next to tax losses carried forward, we found that the categories resulting in temporary differences between the tax basis and IFRS basis of accounting for most Life Sciences companies are: Intangible assets, Property, plant and equipment, Revenue recognition and Employee benefits.

We found that only 5 of the 20 companies (25%) had recognised a deferred tax asset or liability on their balance sheet.


Benchmark of key IFRS topics for the Life Sciences sector

IFRS 1 “First-time Adoption of International Financial Reporting Standards” specifies the procedures that each entity applying IFRS for the first time must follow. In summary, IFRS 1 requires entities to:

identify the first IFRS financial statementsprepare an opening balance sheet at the date of transition to IFRSselect accounting policies that comply with the standards in force at the closing balance sheet date in the first IFRS financial statements, and apply those policies retrospectively to all of the periods presented in the first IFRS financial statementsconsider whether to apply any of the 14 exemptions from retrospective application and apply the four mandatory exceptions theretomake extensive disclosures to explain the transition to IFRS

For companies adopting IFRS as from 1 January 2005, 14 exemptions from retrospective application of IFRS were available. The IFRS 1 exemptions mostly applied by the Life Sciences companies included in this benchmark are further explained in the Financial Statements Analysis section below.

An entity is required to provide disclosures that explain the impact of the transition to IFRS. For example, the first IFRS financial statements should include a reconciliation of:

shareholders’ equity from the previous accounting policies to IFRS at the date of transition and at the end of the last period presented in the entity’s most recent financial statements under previous accounting policies; andnet profit under the previous accounting policies to IFRS for the last period in the entity’s most recent financial statements under previous accounting policies.

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Accounting Issue

Accounting Guidance

First-time adoption of IFRS


Of the 20 companies, 13 were first-time adopters of IFRS in 2005. Based on the financial statements for 2005, the use of the following exemptions from retrospectively application of IFRS were identified:

Share-based payment (IFRS 2)Business combinations (IFRS 3)Employee benefits (IAS 19)Cumulative translation differences (IAS 21)Compound financial instruments (IAS 32)Comparatives for financial instruments (IAS 32/39)

Of the 13 first-time adopters, the number of companies that applied these IFRS 1 exemptions is shown in the diagram below:

Share-based payment (IFRS 2)The exemption available under IFRS 1 is to not account for equity-settled options issued prior to 7 November 2002 or those equity-settled options that were granted after 7 November 2002 but which had vested prior to the later of 1 January 2005 and the date of transition to IFRS. Cash-settled options are exempted from accounting when settled before 1 January 2005.

Of the 13 first-time adopters of IFRS in this European study, 7 of the companies have applied the exemption available under IFRS 1. For the other 6 first-time adopters, the exemption is either not applied or not applicable.

All of the companies in the UK survey “IFRS and its impact on Financial Reporting for the Life Sciences Sector” have applied

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IFRS 2 IFRS 3 IAS 19 IAS 21 IAS 32 IAS 32/39

Financial Statements Analysis – IFRS 1 exemptions

Benchmark study of the application in Europe of IFRS in the Life Sciences Sector 11

the exemption available under IFRS 1 related to share-based payments.

Business combinations (IFRS 3)An entity is not required to restate business combinations that were recorded before the date of the transition to IFRS.

Of the 13 first-time adopters of IFRS in this study, 7 of the companies used this exemption. For the other 6 companies, this exemption was not used or not applicable.

This exemption has also been widely used by the companies included in the UK survey “IFRS and its impact on Financial Reporting for the Life Sciences Sector”. Only 1 of these companies has re-opened acquisitions pre the date of transition leading to intangibles being separately recognised with resulting goodwill being lower than previously stated under UK GAAP.

Employee benefits (IAS 19)The exemption in IFRS 1 allows first-time adopters that adopt a policy of deferring actuarial gains and losses in its defined benefit plans prospectively, to recognise in the IFRS opening balance sheet all actuarial gains and losses arising before the date of transition.

Of the 13 first-time adopters of IFRS in this European study, 6 companies have applied the exemption available under IFRS 1. For the other 7 companies, this exemption was not used or not applicable.

Cumulative translation differences (IAS 21)In the IFRS opening balance sheet the cumulative translation adjustment may be set to zero for all foreign subsidiaries. If the exemption is applied, the gain or loss on disposal of a subsidiary after the date of transition does not include any amount in connection with the cumulative translation adjustment before the date of transition.

Of the 13 first-time adopters of IFRS in this European study, 4 companies have applied this exemption available under IFRS 1.


Our analysis of the 2005 financial statements for the 13 first-time adopters of IFRS, showed that the following accounting standards caused the most adjustments:

Furthermore, IAS 16 “Property, Plant and Equipment”, IAS 20 “Accounting for Government Grants and Disclosure of Government Assistance” and IAS 21 “The Effects of Changes in Foreign Exchange Rates” resulted in adjustments for 2 companies and IAS 17 “Leases” resulted in an adjustment for 1 company.

Management should also calculate deferred taxes in accordance with IAS 12 “Income Taxes” after all other adjustments have been made. The deferred tax balances are calculated by comparing the tax base of each asset and liability with its IFRS carrying amount in the opening IFRS balance sheet. Accordingly, in addition to those standards above, IAS 12 had an impact for most companies.

Based on our analysis of the first-time adopters’ explanations of the impact of the transition to IFRS, we observed the following:

A wide range of standards may have an impact when adopting IFRS. However, as seen also in the UK survey “IFRS and its impact on Financial Reporting for the Life Sciences Sector”, share-based payment (IFRS 2), business combinations (IFRS 3), employee benefits (IAS 19) and intangible assets (IAS 38) were the standards that caused the most adjustments. On the other hand, 2 companies reported that the adoption of IFRS did not result in any adjustments compared with previous local accounting standards.From the 13 first-time adopters included in this analysis, 3 of them reported differences with regard to revenue recognition.

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02468

1012

IFRS2

IFRS3

IAS19

IAS38

IAS2

IAS18

IAS37

IAS32/39

Financial Statements Analysis – IFRS differences


From the 25 companies in the UK survey “IFRS and its impact on Financial Reporting for the Life Sciences Sector”, one of them identified revenue recognition differences compared with previous accounting policies.The first IFRS financial statements of the 11 companies which reported adjustments as a result of the transition to IFRS included the required reconciliations of equity/net results from previously applied accounting policies to IFRS. The disclosure note related to the transition to IFRS should also give sufficient detail for users to understand the material adjustments to the balance sheet and profit and loss account. In this regard, the level of detail provided in the financial statements of the analysed companies significantly differed.

Even with the exemption from full retrospective application of IFRS, the transition process remains complex and time-consuming for many companies. Life Sciences companies should dedicate some time to understanding the impact of IFRS 2 since this standard often causes adjustments. Another area Life Sciences companies need to carefully consider during the transition to IFRS, is the accounting treatment of revenue obtained via long-term research contracts and licensing agreements. Furthermore, due to the high levels of research and development spending by Life Sciences companies, IFRS may impact how companies account for their product development costs.

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Final Thoughts


The use of share-based payment as an employee incentive is common across most industries, but it is in particular common in the Life Sciences sector for instance to reimburse and commit (scientific) finders and founders. Historically, accounting principles have focused on the intrinsic value (difference between the market price of the shares and the exercise price of the option) as a basis to charge the profit and loss account. Under the requirements of IFRS 2 “Share-based Payment”, however, the fair value needs to be determined by the use of a valuation model and the resulting expense recognised over the vesting period.

IFRS 2 applies to all types of share-based payment transactions:

Equity-settled: An entity issues or transfers its own equity instruments, or those of another member of the same group, as consideration for goods or services.

Cash-settled: An entity, or another member of the same group, pays cash calculated by reference to the price of its own equity instruments as consideration for goods or services.

Choice of equity-settled or cash-settled: An entity or the supplier may choose whether the entity settles in cash or by issuing or transferring an equity instrument.

IFRS 2 requires an expense (or an increase in assets, where relevant) to be recognised for goods or services acquired. The corresponding amount will be recorded either as a liability or as an increase in equity, depending on whether the transaction is determined to be cash-settled or equity-settled.

An example of an equity-settled transaction is the issuance of options to employees that give them the right to purchase the entity’s shares (at a discounted price) in exchange for their services.

How should the charge be measured?Shares and share options are often granted to employees as part of their remuneration package, in addition to salary and other employment benefits. IFRS 2 requires an entity to measure the fair value of the employee services received by reference to the fair

Share-based payment

Accounting Issue

Accounting Guidance

Equity-settled transactions


value of the equity instruments granted. It presumes that the fair value of employee services cannot be measured reliably.

In other circumstances, IFRS 2 requires the fair value of the goods or services acquired by an entity to be determined and used as the value for an equity-settled share-based payment transaction. In rare cases, if the fair value of the goods or services cannot be measured reliably, the transactions should be measured indirectly by reference to the fair value of the equity instruments granted.

Measurement dateThe fair value of the equity instruments granted as consideration should be measured at either:

The grant date in the case of employee services; orThe date on which goods are received or services are rendered, in all other cases.

The grant date is the date when the parties have obtained an understanding of all the terms and conditions of the arrangement.

When should a charge be recognised?Goods or services acquired in a share-based payment transaction should be recognised when they are received. For goods, the recognition date will usually be the delivery date. However, sometimes it is less obvious as to when services are received.

The vesting date is normally not relevant for the purchase of goods or services other than employee services. It is, however, relevant for employee services. Where equity instruments vest immediately, management should presume that they represent consideration for employee services already rendered, if there is no evidence to the contrary. Management should therefore recognise the employee services received in full on the date on which the equity instruments are granted.

If, for example, the share options do not vest until the employees or others providing similar services have completed a specified period of service, management should presume that services are to be linearly rendered over that period, referred to as “the vesting period”. IFRS 2 does not distinguish between vesting periods during which the employees have to satisfy specific performance conditions (non-market vesting conditions) and vesting periods

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during which there are no particular requirements other than to remain in the entity’s employment.

A number of variables must be taken into account when the fair values of share options are estimated by applying an option pricing model. The following are significant variables which will drive the estimated fair value:

Volatility: Companies generally consider historical volatility to determine which volatility to use, but most companies have found that the historical volatility may appear to be inconsistent with the requirements of the standard - to form a view on the future expected volatility over the life of the award. Companies will need to consider historical volatility over different time periods, look to market volatility and consider the one-off items in their history or future which may need to be discounted or included. This will require a significant amount of judgement. For unlisted companies, estimating volatility is even more challenging. Generally, the volatility of a listed peer group will be used as a benchmark.

Expected life of awards: In long established companies, history can be the best indicator for the expected life of awards, as the use of share options and the time taken to exercise is well established. However for Life Sciences companies, the history is likely to include under-water options, a high turnover of staff and other circumstances whereby there is insufficient history to establish a discernable pattern. Other than history, the following factors could among others also be taken into account:

The length of vesting period;Price of underlying shares, as experience may indicate that employees exercise once the share price has reached a specified level above the exercise price; andWhether senior employees hold their options longer than more junior employees.

Vesting periodA development-stage Life Sciences company grants share options to its employees. Certain proof of concept and clinical milestones need to be satisfied over the next three years for the options to be exercisable (non-market vesting condition). Furthermore, the employees have to remain working for the company during this period to become entitled to the award.

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Share option pricing models

Example 1


The employees provide their services over the three-year vesting period in exchange for the granted options. The expense should therefore be recognised over this period, and the amount recognised should be based on the best available estimate of the number of options that are expected to vest. The estimated number of options expected to satisfy the non-market vesting conditions should be revised at each balance sheet date.

An expense (or increase in assets if the criteria for asset recognition are met) arises out of a share-based payment transaction. The credit side of the entry will be a liability if the entity has an obligation to settle the transaction in cash. However, if there is no possibility of settling in cash, and the consideration for services will therefore be achieved through the issuance of equity instruments, the credit entry is an increase of equity.

The analysed Life Science companies used share-based payment as follows:

Of the 20 companies, 18 (90%) have granted share-based payment to management and employees.In 9 instances (45%) we noted that also non-employees such as advisors and consultants are part of share-based transactions. In 2 of these instances, the group of non-employees included research institutions.

This is also illustrated in the diagram below:

We noted that 7 companies have used a binomial model for determining the fair value and 10 companies have used a Black-Scholes pricing model. One company reported that both a binomial and a Black-Scholes model had been applied given the different nature of the existing plans.

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Management and employees

Non-employees

Research Institutions

Number of companies

Financial Statements Analysis


The companies disclosed the following regarding their use of share-based payment:

All of the companies with share-based payment arrangements have granted equity-settled plans, while 2 companies also have arrangements accounted for as cash-settled share-based payments. 1 company did not disclose the terms and conditions to the share-based transactions, whereas 1 company did not disclose a movement schedule for the outstanding share options. 1 company did not disclose the fair value of the options as this was deemed immaterial for the financial statements.2 companies reported a change in the plans compared to the comparative year.

The extensive use of share-based payment by Life Science companies is also confirmed by the UK survey “IFRS and its impact on Financial Reporting for the Life Sciences Sector”. Of the 25 companies in the UK survey, 23 incurred a charge in respect of share-based awards compared to the previously reported results under UK GAAP. The average charge for these 23 companies represented 6% of the previously reported UK GAAP result before tax of those companies, with the largest charge representing 27% of the previously reported pre-tax result.

Companies will need to:

Make sure that they have the right share option pricing model considering the type of performance conditions (for example that the entity achieves a specified growth in its share price) that the options have. Remember that whilst models are relatively simple to obtain, it is the assumptions input into the model which are most challenging.Consider the continued appropriateness of the use of incentive schemes. Consider the potential impact on deferred tax and wage taxes from issuing and accounting for share options and other share-based payments.Consider the disclosure requirements. Whilst many companies have focused on the profit and loss account, the next hurdle is to provide all of the extensive disclosures required for the annual report.

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Final Thoughts


Research and development expenditure

Under IAS 38 an intangible asset is recognised when it meets all of the following criteria:

a) it is identifiable;b) the entity has control over the asset; c) it is probable that economic benefits will flow to the entity;

andd) the cost of the asset can be measured reliably.

Furthermore, all of the following must be demonstrated prior to capitalisation of development expenditure:

Technical feasibilityClear intention to complete and use/sell itAbility to use/sell itAbility to generate probable future economic benefitsAvailability of adequate resources to complete developmentAbility to reliably measure the expenditure attributable to the asset

Under IFRS, development costs must be capitalised when the all the above requirements are met. Accordingly, an accounting policy that requires expensing all development costs as incurred regardless of the criteria mentioned above, is not acceptable.

It is only the development costs incurred subsequent to the date on which the recognition criteria were met that should be recognised as an intangible asset. The development costs which incurred prior to this date should be expensed and should not be capitalised as part of the intangible asset.

There is no definitive starting point for the capitalisation of internal development costs. Management must use its judgment, based on the facts and circumstances of each project. However, a strong indication that an entity has met all of the above criteria arises when it files its submission to the regulatory authority for final approval of a drug. It is the clearest point at which the technical feasibility of completing the asset is proven, and this is the most difficult criterion to demonstrate.

In many (but not all) circumstances, filing the submission to the regulatory authority for final scientific regulatory approval will

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Accounting Issue

Accounting Guidance


therefore represent the starting point for capitalisation. If it is not yet considered probable that regulatory approval will be obtained, development costs should continue to be expensed until the regulatory approval is obtained.

The following industry specific factors should be considered when applying these general criteria:

Technical feasibility of completing the intangible asset so that it will be available for use:

Demonstrating the technical feasibility of new compounds prior to submission for final regulatory approval may be difficult, although it is not impossible. The nature of the compound must be considered. Is it, for example, a drug in a proven therapeutic category, using proven delivery methods? Or is it a medicine for which there is a significant unmet need and which may therefore be treated favourably by the regulatory authorities? In some cases, the probability of regulatory approval will be clear from the Phase 3 clinical trial results, and capitalisation can begin thereafter. In other cases, recent regulatory approval experience could cast some doubt on the probability determination and further development costs may need to be expensed.

In either case, filing for final regulatory approval creates a strong presumption that management believes a drug is technically feasible - although neither the application nor approval itself is necessarily sufficient. Whatever assessment management makes, that assessment should be applied consistently. For instance, a decision to start production of inventory or launch a marketing campaign is persuasive evidence that management thinks regulatory approval is probable; therefore, the criterion is satisfied.

The intangible asset will generate probable future economic benefits, or demonstrate the existence of a market or the usefulness of the asset if it is to be used internally:

Pharmaceutical and Life Sciences companies typically develop drugs to meet specific therapeutic needs. They assess the potential market for those drugs during various stages of development, and constantly reassess whether it makes economic sense to proceed. For example, rival drugs may have entered the market or other factors reduced their commercial

Technical feasibility

Ability to generate probable future economic benefits


potential or probability of successful approval, and all such issues should be considered.

This criterion may be demonstrated before filing for regulatory approval, if, for example, other entities are actively interested in purchasing the compound or the company has market evaluations showing the compound’s sales potential, once it is approved. Exceptions might exist where an entity has obtained regulatory approval of a drug but does not have (and cannot obtain) the manufacturing or marketing capacity to produce and sell it.

The factors to consider in valuing inventories before product approval are similar to the above factors regarding development capitalisation. For instance, assertions underlying the probability of economic benefits would affect both inventory valuation and the decision whether to capitalise development costs.

Background and issueAn entity is developing a vaccine for HIV that has successfully completed Phases 1 and 2 of clinical testing. The drug is now in Phase 3 of clinical testing. Management still has significant concerns about securing regulatory approval and has not started manufacturing or marketing the vaccine.

Should management start capitalising development costs at this point?

SolutionNo, management should not capitalise the subsequent development costs, because the project has not met all the capitalisation criteria laid down by the IFRS.

From the analysis of the 20 financial statements subject to this benchmark we observed the following:

2 companies have capitalised internal development expenses. 4 companies have acquired in-process research and development in a business combination.Of the 18 companies that have not capitalised internal development expenses, 6 companies have specified when they consider the recognition criteria to be met. For one company the filing for final regulatory approval represents the starting

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Ability to use or sell the intangible asset

Example



point for capitalisation, while for 5 companies the starting point will be the final regulatory approval. Of the remaining 12 companies that have not capitalised internal development expenses, 5 companies considered that regulatory, clinical or field trial risks inherent to the development of products precluded them from capitalising internal development costs. The R&D expense relative to total operating expenses is illustrated in the chart below. On average the R&D expense relative to total operating expenses is 47%. The nature of the R&D expenses disclosed included the following types of expenses:

direct labourallocated overhead and facility expensesclinical trialsamortisation of technologies depreciation of R&D equipmentmaterialscosts of patents and licencesthird party research expensescontract servicesvalidation costsshare-based paymentimpairments

Two of the companies analysed in this benchmark study have capitalised internal development costs, while none of the companies in the UK survey “IFRS and its impact on Financial Reporting for the Life Sciences Sector” have capitalised any such costs.

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R&D expense relative to total operating expenses

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0-20%

21-40%

41-60%

>-60%


Furthermore, 4 of the companies analysed in this benchmark study have capitalised in-process research and development acquired in a business combination. External research and development costs have also been capitalised (e.g. as patents) by companies included in the UK survey “IFRS and its impact on Financial Reporting for the Life Sciences Sector”.

Under IFRS, development costs must be capitalised when all the criteria are met. Due to the high levels of research and development expenditure in the Life Sciences sector, this is an important requirement for companies within the sector. As seen from this study, however, limited amounts of development expenses have been capitalised. This can be explained by the fact that many of the analysed Life Sciences companies still are in early stages of their drug development process.

The Life Sciences sector is not the only sector wrestling with how to apply the rules in a practical way but it does benefit from having an external party that determines when products can be sold. However, regulatory approval should not be used by default as the definitive starting point for the capitalisation of internal development costs for Life Sciences companies. Management must use its judgment, based on the facts and circumstances of each project.

Final Thoughts


The current standard on business combinations, IFRS 3, was issued on 31 March 2004. The standard provides recognition criteria for acquired intangible assets, with the result that many intangible assets which would previously have been subsumed within goodwill will now have to be separately identified, valued and capitalised on the balance sheet.

Under IFRS 3 and IAS 36 “Impairment of Assets” – Goodwill is not amortised through the profit and loss account but is subject to an annual impairment test.

Based on IFRS 3, all business combinations must be accounted for using the purchase method of accounting. An important feature of this method is fair value accounting at the acquisition date (i.e. the date on which a company effectively obtains control of the acquiree). At this date the acquirer allocates the cost of the acquisition to the acquiree’s identifiable assets, liabilities and contingent liabilities that satisfy the recognition criteria at their fair values.

The standard requires all the identifiable non-monetary assets without physical substance acquired to be recognised as intangible assets separately from goodwill. An intangible asset is identifiable when it either arises from contractual or other legal rights or is separable i.e. capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability. The most common intangible assets for Life Science companies are likely to include:

In-process research and development costs PatentsUnpatented technologyLicensing or royalty agreementsCustomer contracts and related relationshipsNon-contractual customer relationshipsProduction processes or know-howTrademarksNon-compete agreements

The main type of “asset” of an acquired company that does not meet the criteria to be capitalised as an intangible is its workforce.

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Business combinations including goodwill and other intangible assets

Accounting Issue

Accounting Guidance


How should an entity account for in-process research and development efforts that the acquiree has undertaken?

BackgroundEntity A, a large pharmaceutical group, acquires entity B, a small Life Sciences company. B has incurred significant research costs in connection with two new drugs that have been undergoing clinical trials. One drug has not been given regulatory approval, although A expects that approval will be given within two years. The other drug has recently received regulatory approval. The drugs’ revenue-earning potential was one of the principal reasons why A decided to acquire B.

SolutionThe fair value of the rights to both drugs should be recognised. The fair value of the first drug should reflect the probability and the timing of the regulatory approval being obtained. Probable future economic benefits are presumed in respect of the asset acquired, and an asset is recognised. Subsequent research expenditure should be expensed in accordance with IAS 38 until the approval date. In the meantime the recognised asset is tested for impairment on a yearly basis.

The rights to the second drug also meet the recognition criteria in IAS 38 and should be recognised. The approval means it is probable that future economic benefits will flow to entity A and this will be reflected in the fair value assigned to the intangible asset.

What assets, which did not qualify for recognition before the acquisition, should be recognised as part of the fair value of identifiable assets and liabilities?

BackgroundEntity X, a Life Sciences company, has developed a number of drugs for which it has received regulatory approval and registered patents. Entity X also owns the marketing rights to a number of drugs developed by other businesses. Sales of the drugs generate significant revenue, which can be used to estimate the patents’ fair value. X has not recognised an intangible asset in connection with these patents and rights, since the development costs did not satisfy the IAS 38 criteria at the time they were incurred. Entity Y, a competitor, acquires entity X.

Example 1

Example 2


SolutionEntity Y should recognise an intangible asset in connection with the patents and rights as they satisfy the recognition criteria in IAS 38 and the fair value can be measured reliably. The fair value of an intangible asset acquired in a business combination can normally be measured with sufficient reliability to be recognised.

5 of the 13 first-time adopters of IFRS included in the study have made adjustments for non-amortisation of goodwill following the adoption of IFRS.

18 of the 25 companies in the UK survey “IFRS and its impact on Financial Reporting for the Life Sciences Sector” have made adjustments for non-amortisation of goodwill and some of the benefits to the reported results have been significant, ranging from a few percent to 3 times the previously reported results under the previous accounting policies.

The acquisition process has become more complex. There is need for greater evaluation of the target business so that intangible assets can be fairly valued at the time of acquisition, which is likely to require an external valuation exercise. There will be greater scrutiny to ensure intangibles have been properly identified and to establish what the remaining goodwill represents.

As well as affecting the structure, price and accounting for potential deals, the recognition of intangible assets and their subsequent amortisation (often over short useful lives) will have an impact on the results of the acquired entity, key performance indicators, share options and management targets. Furthermore, there may be more volatility in reported results as a result of impairments due to the more frequent and rigorous impairment testing of goodwill and other acquired intangibles.

Companies with goodwill on their balance sheet need to:

determine the cash generating units to which the goodwill relates and perform the impairment review at that levelestablish a methodology for carrying out the reviews, which is agreed with their auditors ensure the appropriate valuation techniques are used, which will include establishing the correct discount value, having the right cash flows and having the correct terminal value

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Final Thoughts


Revenue recognition

IAS 18 “Revenue” requires companies to recognise revenue when there is a gross inflow of economic benefits during its ordinary course of business.

Companies undertake business in many different ways and there is no substitute for reviewing your own revenue recognition model. IAS 18 is not a standard with prescriptive rules and therefore the practical application requires judgement which in itself could give rise to differences with previous accounting policies.

For example, companies in the Life Sciences industry often enter into collaboration arrangements for research and development. Such arrangements typically include the following attributes:

Upfront feesMilestone paymentsLicense feesOngoing support of technology licensed out and further development of technologyRoyalties

Multi element contractsEntities may bundle the sale of a number of goods and services into one contract. A multiple element revenue contract should generally be separated into its constituent parts and each part accounted for separately, unless the commercial effect of each transaction cannot be understood without considering the separate components as a single transaction.

Where the performance of one element of a contract is closely linked to the performance of another, it may be more appropriate to treat the two elements as one contract. Two elements are closely linked if the commercial effect of one element cannot be properly understood without considering the commercial effect of the other one. The terms of each multiple element contract should therefore be carefully considered to ensure that the correct treatment is applied.

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Accounting Issue

Accounting Guidance


General revenue recognition criteriaThe general revenue recognition criteria is that revenue is recognised when:

(a) it is probable that the economic benefits associated with the transaction will flow to the entity; and

(b) the amount of revenue can be measured reliably.

More specific recognition guidance is set out below for key items of revenue within the Life Sciences industry:

ServicesWhen the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all of the following conditions are satisfied:

(a) the amount of revenue can be measured reliably;(b) it is probable that the economic benefits associated with the

transaction will flow to the entity;(c) the stage of completion of the transaction at the balance

sheet date can be measured reliably; and(d) the costs incurred for the transaction and the costs to

complete the transaction can be measured reliably.

Royalties and licence feesRoyalty revenue arises from the sale of rights to use an intangible asset, often for a defined period of time. Revenue should be recognised on an accrual basis in accordance with the substance of the royalty agreement. However, if the receipt of the revenue is contingent on some future event, the revenue should only be recognised when it is probable that revenue will be received.

Product salesRevenue from the sale of goods should be recognised when all the following conditions have been satisfied: (a) the significant risks and rewards of ownership of the goods

have been transferred to the buyer;


(b) the seller retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

(c) the amount of revenue can be measured reliably; (d) it is probable that the economic benefits associated with the

transaction will flow to the seller; and(e) the costs incurred or to be incurred in respect of the

transaction can be measured reliably.

Government grantsRevenue should be recognised when the conditions for their receipt have been met and there is reasonable assurance that the grant will be received.

Under IFRS, grants related to income are sometimes presented as a credit in the profit and loss account, either separately or under a general heading such as “other operating income”. Alternatively, grants are deducted in reporting the related expense.

Payments received to conduct development and continuing involvement

BackgroundCompany C owns a new compound and has contracted with Company D to complete the development and apply for regulatory approvals. Company C will make upfront payments and milestone payments to Company D for the development services as required by the contract. Company C will also grant Company D exclusive marketing rights for the drug in Japan, if the development is successful. Company C will retain the marketing and other intellectual rights in the rest of the world and will supply Company D with the drug for sale in Japan at cost plus a normal margin for the production.

How should payments received from a third party to conduct development activities be recognised where the development company has continuing involvement with the product?

SolutionCompany D should defer the upfront payment over the development period, recognising revenue considering the stage of completion. Milestone receipts should be recorded as revenue when earned – when the milestone is achieved (e.g. receipt of

Example 1


stage 3 approvals). Costs incurred by Company D under this development agreement should be classified as cost of services provided (cost of goods sold).

If Company D expects to incur costs in excess of the reimbursement, a provision for the excess costs should be immediately recognised. This provision should be recognised via expense, unless the compound is in a stage of development where capitalisation is required under IAS 38.57. Such excess internal development costs would then represent its holding of the Japanese marketing rights.

In these arrangements, consideration must also be given as to whether the contractual payments all represent fair value. If Company C makes significant milestone premiums but receives an abnormal supply premium, the fair values should be assessed, and part of the milestone may need to be deferred as it potentially represents part of the supply contract.

Government grants BackgroundEntity A is awarded a government grant of 60,000 receivable over three years (40,000 in year 1 and 10,000 in each of years 2 and 3), contingent on creating 10 new jobs and maintaining them for three years. The employees are recruited at a cost of 30,000, and the wage bill for the first year is 100,000, rising by 10,000 in each of the subsequent years.

Government grants should be recognised as income over the periods necessary to match them with the related costs, which they are intended to compensate, on a systematic basis. They should not be credited directly to shareholders’ equity.

How should management recognise a government grant intended to compensate an entity for costs incurred?

SolutionThe income of 60,000 should be recognised over the three-year period to match the related costs. The total costs are 360,000 (30,000 + 100,000 + 110,000 + 120,000).

Example 2


In year 1, 21,667 (130/360 x 60,000) of the 40,000 received from government will match the related costs of 130,000 incurred during the year, and should therefore be recognised as income. The amount of the grant that has not yet been credited to income (that is 18,333, being 40,000 of cash received less 21,667 credited to income) is considered deferred income and reflected in the balance sheet as such. In year 2 and year 3, 18,333 (110/360 x 60,000) and 20,000 (120/360 x 60,000) respectively should be recognised as income.

A company is required to present on the face of the profit and loss account or to disclose in the notes the amount of revenue recognised during the period for each significant revenue category. Furthermore, it is required to disclose the accounting policies adopted for the recognition of revenue for each significant category of revenue.

From the analysis of the 20 financial statements subject to this benchmark, we noticed that accounting policies and/or amounts of revenue were disclosed for different revenue categories as follows:

The table shows, for example, that 7 companies had disclosed a revenue recognition accounting policy for license fees, whereas 5 companies have disclosed the amounts of revenue recognised from licence fees.

Accounting policy Amounts disclosed separately

License fees 7 5Royalties 7 4Service fees 7 4Government grants or other grants

13 3

Product revenue 9 6R&D collaboration 10 4Other 1 3



From the 20 companies, the number of companies which disclosed accounting policies and amounts of revenue, respectively, for the identified revenue categories is also illustrated in the following graph:

The “Other”-category includes revenue such as milestone payments (1 company), sale of product rights (1 company) and sale of products (1 company).

From the analysis of the financial statements subject to this benchmark, we observed the following:

All companies reported revenue recognition as a significant accounting policy, including the policy per significant category of revenue.Of the 20 companies, 6 (30%) disclosed one single revenue amount, whereas the accounting policies indicated more than one significant revenue category. 14 companies (70%) disclosed amounts per significant category of revenue. However, this includes 4 companies which disclosed the total revenue from R&D collaboration agreements whereas such arrangements may include revenue elements that should be classified within one of the other categories.3 companies specifically reported government grants separately in revenues, where other companies reported grants as a deduction of (R&D) expenses or within other income.

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02468

101214

Licen

ses

Royalt

ies

Servic

es

Grant

s

Produc

ts

R&D colla

b.

Other

PoliciesAmounts


This area remains complex and the requirement to apply principles could give rise to different practices within the industry and could also give rise to differences between IFRS and local accounting policies.

PricewaterhouseCoopers delivers specific revenue recognition training to help companies work through the principles and highlight potential GAAP differences.

A company’s accounting policies for revenue recognition should be disclosed for each significant category of revenue. It is not sufficient to replicate the IAS 18 revenue recognition criteria for the different types of revenue. A company is required to tailor its revenue recognition policies so that these reflect its actual revenue/distribution channels. The policies should also disclose whether multiple element contracts exist and whether these contracts have been separated into its constituent parts and accounted for separately.

Final Thoughts


Management must account for the tax consequences of transactions when the transactions are recognised in the financial statements. The tax payable based on taxable profit seldom matches the tax expense estimated from pre-tax accounting profit. The mismatch occurs because IFRS recognition criteria for items of income and expense are different from the recognition criteria of the applicable tax law.

IFRS adopt a full provision balance sheet approach to tax accounting. The recovery of all assets and the settlement of all liabilities are assumed to have future tax consequences that can be estimated reliably and cannot be avoided.

When accounting for taxes the tax base of assets and liabilities needs to be determined. The tax base of an asset or liability is the amount attributed to it for tax purposes. The tax base is compared to the carrying amount of assets and liabilities in order to determine the temporary differences.

The tax effect is calculated as follows:

Taxable temporary differences arise when an asset’s carrying amount is greater than its tax base or when a liability’s carrying amount is less than its tax base. A deferred tax liability should be recognised for taxable temporary differences.

Deductible temporary differences arise when: an asset’s carrying amount is less than its tax base; or when a liability’s carrying amount is greater than its tax base. A deferred tax asset should be recognised for deductible temporary differences.

Carrying amount of assets or liabilities

-Tax base of assets or liabilities

=

Taxable or deductible temporary differences

Taxable or deductible temporary differences

X Tax rate =Deferred tax

liabilities or assets

Deferred tax

Accounting Issue

Accounting Guidance


Deferred tax assets may also arise from unused tax losses that are carried forward for tax purposes. These are calculated as follows:

A deferred tax asset shall be recognised for the carry-forward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised.

IssueShould management recognise a deferred tax liability for development costs that are treated as an asset for accounting purposes but are expensed immediately for tax purposes?

Background Entity F capitalised the development costs relating to a diabetes drug that has been approved and is being marketed as an intangible asset (450).

Tax law permits entity F to deduct these costs when incurred. Management has therefore recognised the costs as an expense for tax purposes. The income tax rate is 30%.

SolutionYes, management should determine the tax base of the intangible asset (development costs). The tax base is nil since the development costs already have been recognised as costs for tax purposes. Consequently, entity F has a taxable temporary difference in respect of the intangible asset of 450 (carrying amount of 450 minus tax base of 0). Management should recognise a deferred tax liability (30% of 450) in respect of the taxable temporary difference.

From the analysis of the financial statements subject to this benchmark we observed the following:

Of the 20 companies, 5 companies had recognised a deferred tax position on their balance sheet. 15 companies had not recognised a deferred tax position but

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Unused tax losses X Tax rate = Deferred tax assets

Example



disclosed why assets or liabilities had not been recognised.Of the 20 companies, 19 companies (95%) disclosed unused tax losses, mainly relating to losses incurred as a result of research activities. Next to tax losses carried forward, the main categories resulting in most temporary differences are (see table below):

intangible assets property, plant and equipment revenue recognition employee benefits

The taxable or deductible temporary differences caused by intangible assets include 3 companies which benefit from a tax credit as a result of R&D activities.

6 companies included a category “other differences” which resulted in a deferred tax position without providing further details.

The changes in the Dutch corporate income tax as from 2007 will have an effect on the tax position in the financial statements of Dutch companies. The most important aspects are the following:

The limitations in fiscal depreciation of fixed assets can lead to more deferred tax assets as from 2007. As from 2007 the term for carry forward of tax losses is limited to 9 years. This limitation may result in lower deferred tax assets. This is already relevant in the financial statements for 2006.The deferred tax assets and liabilities in the financial statements 2006 must be calculated taking into account the enacted reduction of the tax rates as from 2007.

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Asset/liability category Temporary differences

(positive)

Temporary differences

(negative)Intangible assets 6 3Property, plant & equipment

5 5

Employee benefits 3 5Revenue recognition 2 1Share-based payments 1 1Inventories 2 3Provisions 1 2

Dutch corporate income tax as from 2007


Income tax is an area which may require significant judgement and use of estimates. For example, a deferred tax asset shall be recognised for the carry-forward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised. Furthermore, recognition of liabilities for anticipated tax audit issues will have to be based on estimates of whether additional taxes will be due or not.

Another hurdle is to provide all of the extensive disclosure requirements related to income taxes required for the annual report.

Final Thoughts


Other adjustments and accounting areas

As well as the adjustments and impact of IFRS set out in the preceding pages, other adjustments and accounting areas to be aware of include:

ProvisionsOf the 13 first-time adopters of IFRS, 3 companies reported other differences between local accounting policies and IFRS. These differences are related to the following items:

Under IFRS, an obligation (legal or constructive) to incur charges as a result of a past event must exist in order to recognise a provision.For a restructuring, the characteristics of an obligating event are specified in IAS 37. In addition to the general recognition criteria, these specific criteria must be met before a restructuring provision can be recognised under IFRS.Planned repair and maintenance expenses that will arise at a future date do not meet the definition of a present obligation; therefore a provision in accordance with IAS 37 cannot be established. Companies can apply the so-called component approach to account for these expenses.IFRS require recognition of the best estimate of the amount that would be required to settle an obligation. Where the effect of the time value of money is material, the measurement is required to be on a present value basis.

Defined benefit pension schemesFor companies with arrangements to be classified as defined benefit schemes under IFRS, differences with local accounting policies will often exist. Even if there are no differences between IAS 19 and the current standard, application of the IFRS 1 exemption regarding actuarial gain and losses may result in an IFRS adjustment.

Lease accountingOnly 1 company identified differences regarding the classification of operating and finance leases, but going forward companies will still need to go through the process of identification and determination to reach that conclusion, especially taking into account the new IFRIC 4 on determination whether an arrangement contains a lease.

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Making it more than just about the numbers – embedding IFRS

Having completed the transition, it is now time to have IFRS underpin the numbers and the business as a whole. If IFRS is not embedded into the organisation, management could find it difficult to meet the expectations of both their internal and external stakeholders.

Most companies have taken a tactical approach to IFRS, often driven by necessity, due to timing and resource constraints. Some companies have delegated the preparation of external reporting to external contractors or consultants, therefore IFRS reports are produced outside the company’s normal reporting systems and there is limited knowledge transfer to other staff.

The goal of embedding IFRS is to make compliance with the new reporting standards “business as usual”. Management needs to establish disciplines and procedures that can be repeated, period after period, in an efficient and robust manner, without reliance on resources, processes and systems that do not exist on an every day basis - effectively having to be “switched on” for external financial reporting. Manual intervention and spreadsheets are part of the immediate solution for some, which can increase the risk of error, be inefficient and make effective control more difficult.

The technical skill required by the finance team has been hugely underestimated. Companies need to consider how to keep their organisation up to date on the new standards or incur additional costs from external advisers.

Many commentators and regulators have begun to question the presentation of information by companies who have sought to adjust items to take account of some of the impact of IFRS. The rationale is that the adjusted measures are a more representative measure of the underlying performance of the Company. If it becomes recommended, or even, required practice to report only IFRS numbers, it will be just another reason to ensure IFRS is embedded within the organisation.

Embedding IFRS will need you to consider:

ProcessesData systems and technologyControlsPeople capabilityOrganisational structurePlanning strategies and reporting

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Appendix A: Overview of companies included in the benchmark

The 20 companies included in this benchmark are:

Arpida Ltd (Switzerland)BioGaia AB (Sweden)Crucell NV (The Netherlands)Cytos Biotechnology AG (Switzerland)Devgen NV (Belgium)Epigenomics AG (Germany)Fornix BioSciences NV (The Netherlands)Galapagos NV (Belgium)Ion Beam Applications SA (Belgium)ImmuPharma Plc (United Kingdom)Innogenetics NV (Belgium)MediGene AG (Germany)OctoPlus NV (The Netherlands)OncoMethylome Sciences SA (Belgium)Pharming Group NV (The Netherlands)Schwarz Pharma AG (Germany)Speedel Holding Ltd (Switzerland)SR Pharma Plc (United Kingdom)Stallergenes SA (France)ThromboGenics NV (Belgium)


Your contacts

For more information on PricewaterhouseCoopers services for Life Sciences companies, please contact:

Arwin van der LindenLeader of the Dutch Life Sciences Practice

Telephone: (020) 568 47 12E-mail: [email protected]

Alexander SpekPartner PwC Accounting Advisory Services

Telephone: (020) 568 43 20E-mail: [email protected]


Legal Disclaimer

This article has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this article without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this article, and, to the extent permitted by law, PricewaterhouseCoopers Accountants N.V., its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this article or for any decision based on it.

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