US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 4

Chapter 4: Business Combinations & Asset Acquisitions

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4-1 Asset acquisition versus business combination – Scenario 1

Background

Company A owns the rights to several drug compound candidates that are currently in Phase I of development. Other than the stage of development, the compounds have no other similarities and are designed to treat disparate conditions. Company A’s activities primarily consist of research and development (R&D) on these compounds. Company A employs management and administrative personnel as well as scientists, who are vital to the R&D.

Company B acquires the rights to the drug compound candidates along with Company A’s workforce composed primarily of scientists. None of the acquired drug compounds are similar. Two of the compounds are the predominant assets acquired.

Question: Should Company B account for the transaction as a business combination or an asset acquisition?

Solution

Company B should perform the screen test and consider whether substantially all of the purchase price is concentrated in a single identifiable asset or a group of similar identifiable assets. Based on the fact that none of the acquired compounds are similar, and two of the compounds are the predominant assets acquired, the screen test is likely not met and a full assessment must be performed. In the full assessment, Company B will need to consider whether it has acquired inputs, substantive processes, and outputs. Company B would likely conclude that there are no outputs acquired because the compounds are in early stage of development. Company B would need to consider whether the scientists hired by Company B through the transaction would meet the definition of an organized workforce that can be combined with an input and process to convert or develop an output. Factors to consider may include: the employees’ roles, whether the workforce is subject to contracts with employers or service organizations, as well as the nature and stage of the assets acquired. A conclusion that an organized workforce was acquired would result in Company B acquiring a business as opposed to assets.

This example assumes adoption of Accounting Standards Update 2017-01, Clarifying the Definition of a Business. Non-public business entities that have not yet adopted this guidance must make an assessment under the previous guidance.

ASU 2017-1 is effective for non-public business entities for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted, including adoption in an interim period.  Prospective application is required.

Relevant guidance

ASC 805-10-55-3A defines a business as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. Further, to be capable of this, a business must have, at a minimum, an input and a substantive process that together significantly contribute to the ability to create an output.

ASC 805-10-55-5A through 55-5C introduce a screen test to be performed prior to the full assessment. The screen test states that if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, the set is not considered a business and no further analysis is required.

If the screen test is not met, then a company must perform further assessment. The framework for this assessment is discussed in ASC 805-10-55-5D through 55-9.

4-2 Asset acquisition versus business combination – Scenario 2

Background

Company A purchases a legal entity from Company B that contains the rights to a Phase 3 (in the clinical research phase) compound being developed to treat diabetes, or the in-process research and development (IPR&D) project. Included in the IPR&D project is the historical know-how, formula protocols, designs, and procedures expected to be needed to complete Phase 3. The legal entity also holds an at-market clinical research organization contract and an at-market clinical manufacturing organization contract. No employees, other assets, or other activities are transferred.

Question: Should Company A account for the transaction as a business combination or an asset acquisition?

Solution

Company A should perform the screen test and consider whether substantially all of the purchase price is concentrated in a single identifiable asset. The clinical research organization contract and the clinical manufacturing organization contract are at market rates and could be provided by multiple vendors in the marketplace. Therefore, there is no fair value associated with these arrangements. As a result, all of the consideration will be allocated to the IPR&D project. As such, Company A should account for the transaction as an asset acquisition.

This example assumes adoption of Accounting Standards Update 2017-01, Clarifying the Definition of a Business. Non-public business entities who have not yet adopted this guidance must make an assessment under the previous guidance.

ASU 2017-1 is effective for non-public business entities for fiscal years beginning after December 15, 2018, and interim periods within fiscal years beginning after December 15, 2019. Early adoption is permitted, including adoption in an interim period.  Prospective application is required.

Relevant guidance

ASC 805-10-55-3A defines a business as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. Further, to be capable of this, a business must have, at a minimum, an input and a substantive process that together significantly contribute to the ability to create an output.

ASC 805-10-55-5A through 55-5C introduce a screen test to be performed prior to the full assessment. The screen test states that if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or group of similar identifiable assets, the set is not considered a business and no further analysis is required.

If the screen test is not met, then a company must perform further assessment. The framework for this assessment is discussed in ASC 805-10-55-5D through 55-9.

4-3 Accounting for acquired IPR&D

Background

Company A is in the pharmaceutical industry and owns the rights to several product (drug compound) candidates. Company A also has a product candidate that received FDA approval, but for which it has not yet started production. Company A’s activities only consist of R&D on these product candidates.

Company B, also in the pharmaceutical industry, acquires Company A, including the rights to all of Company A’s product candidates, testing and development equipment. Company B also hires all of the scientists formerly employed by Company A, who are integral to developing the acquired product candidates. Company B accounts for this transaction as an acquisition of a business.

Question: How should Company B account for the acquired IPR&D?

Solution

Company B should measure the acquired IPR&D at its acquisition date fair value and record it as an indefinite-lived IPR&D intangible asset. Subsequent to the acquisition, the acquired IPR&D would be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. To do so, Company B may elect to perform a qualitative impairment assessment under ASC 350-30-35-18A. If the qualitative assessment either failed or was not used, Company B would perform a quantitative assessment comparing the fair value of the IPR&D asset to its carrying value.

Incremental R&D costs subsequent to the acquisition would be expensed. Once the IPR&D asset becomes available for use, it should be amortized over its estimated useful life.

Company A’s product candidate that has received FDA approval (it is no longer “in-process”) would be recognized as a finite-lived intangible asset at the date of acquisition, separate from the acquired IPR&D, and amortized over its estimated useful life. The production, testing and developing equipment would generally be separately recognized as tangible assets, measured at fair value, and depreciated over their estimated useful lives.

Relevant guidance

Under ASC 805, acquired IPR&D continues to be measured at its acquisition date fair value but is accounted for initially as an indefinite-lived intangible asset (i.e., not subject to amortization).

Post-acquisition, acquired IPR&D is subject to impairment testing, as required by ASC 350-30-35, until the completion or abandonment of the associated R&D efforts. If abandoned, the carrying value of the IPR&D asset is written off. Once the associated R&D efforts are completed, the carrying value of the acquired IPR&D is reclassified as a finite-lived asset and amortized over its useful life.

Incremental costs incurred on IPR&D after the acquisition date are expensed as incurred, unless there is an alternative future use, under ASC 730-10-25.

4-4 Unit of account – IPR&D

Background

Company A acquires Company B, a small pharma company, in a transaction accounted for as an acquisition of a business under ASC 805. Company B is developing a drug compound that is expected to become a leading product for its therapeutic indication. The project reached market approval in Canada, the US, and Europe just prior to acquisition, and regulatory approval is currently being pursued in Japan and Brazil. The project has been scaled to allow for additional trials to meet the regulatory requirements in each future jurisdiction.

Question: What is the unit of account for the acquired IPR&D asset?

Solution

It depends. Industry practice would suggest that Company A may recognize at least two, and potentially up to five, separate assets: one intangible asset representing the rights to the compound in all market-approved jurisdictions (or a separate asset for each of the three market approved jurisdictions) and one IPR&D asset for the portion still being developed (or two, if separated by jurisdiction). The late stage of development combined with the plan to scale trials to meet regulatory requirements in each future jurisdiction may suggest that disaggregation by jurisdiction of the intellectual property being developed is warranted. However, the specific facts and circumstances would need to be assessed to determine if the risk of further development, along with the associated costs would be different in the two jurisdictions.

Relevant guidance

ASC 350-30-35 provides factors to consider in determining the appropriate unit of accounting both for recognition and subsequent impairment assessments of intangible assets. This determination for acquired IPR&D can be complex when an approved drug may ultimately benefit various jurisdictions. One approach is to record separate jurisdictional assets for each jurisdictions. Another approach is to record a single global asset. When making the unit of account determination, companies may consider, among other things, the following factors:

  • Phase of development of the related IPR&D project
  • Nature of the activities and costs necessary to further develop the related IPR&D project
  • Risks associated with the further development of the related IPR&D project;
  • Amount and timing of benefits expected to be derived from the developed asset
  • Expected economic life of the developed asset
  • Whether there is an intent to manage advertising and selling costs for the developed asset separately or on a combined basis
  • Once completed, whether the product would be transferred as a single asset or multiple assets

4-5 Core or base technology

Background

Company A acquired Company B, which is accounted for as an acquisition of a business under ASC 805. At the acquisition date, Company B produced and sold a medical scanner that includes Version 1.0 of its proprietary software. Company B was also conducting R&D related to significant improvements to Version 1.0 (Version 1.0 was being modified and would be partly reused in Version 2.0) that Company B expects to sell in their new scanner. Company B believes there is potential for additional enhancements that may be included in the next generation scanner, including new software Version 3.0. Version 3.0 was not yet under development at the date of the acquisition.

Question: How should Company A account for the various versions of the technology?

Solution

The fully developed and commercialized technology present in Version 1.0 would be recognized as a separate software technology asset and amortized over its useful life. The IPR&D activities related to the new technology to be included in Version 2.0 would be recognized as an indefinite-lived IPR&D asset. As Version 3.0 is not yet under development, and, therefore, lacks any substance as IPR&D, there would not be an asset recognized for Version 3.0.

Company A would also consider whether a separate enabling technology asset should be recognized for Version 1.0. The IPR&D guide indicates that the enabling technology, in order to be separately identifiable, should exhibit the same characteristics between the various products in which it is used.  If the enabling technology shares the same useful life, growth risk, and profitability of the products in which it is used, a separate asset would likely not be recognized. Company A would likely not record a separate enabling technology as the design and technology of Version 1.0 is not used in the same form in the later versions (i.e., it is further enhanced and altered). As a result, the value of the Version 1.0 technology that is able to be reused in later versions would be included as part of the Version 1.0 intangible asset as it is not considered to be a separate enabling technology asset.

Relevant guidance

When IPRD involves enhancements to existing technologies, the allocation of value between a proven technology and an unproven (incomplete) research project can be difficult to measure. The AICPA’s Accounting and Valuation Guide on acquired intangible assets used in research and development activities (the IPR&D Guide) notes that value should be allocated to all identifiable assets, which could include IPR&D.

As described in section 8.2.4.1 in PwC’s Business Combinations guide, “[The IPR&D Guide] also eliminated the concept of core technology and introduces the concept of enabling technology which is intended to have a narrower definition. Enabling technology is…underlying technology that has value through its combined use or reuse across many product or product families. Examples of enabling technology provided in the IPR&D Guide include a portfolio of patents, a software object library, or an underlying form of drug delivery technology. If enabling technology meets the criteria for recognition as an intangible asset, it could be a separate unit of account if it does not share the useful life, growth, risk, and profitability of the products in which it is used. The IPR&D Guide indicates that enabling technology will be recognized as a separate asset less frequently than core technology had previously been recognized, and that the introduction of enabling technology is not expected to significantly contribute to the amount of recognized goodwill. As a result, elements of value previously included in core technology likely will be recognized separately as identifiable intangible assets that increase the value of developed technology and/or an IPR&D asset.”

While the IPR&D Guide is non-authoritative, it reflects the input of financial statement preparers, auditors, and regulators and serves as a US GAAP accounting and reporting resource for entities that acquire IPR&D.

4-6 Assets acquired in a business combination to be used in commercial products and R&D

Background

Company A is the owner of patented intellectual property used in medical devices that it currently markets and sells to customers. Company A is also using the intellectual property in certain ongoing R&D activities.

Company B acquires Company A in a business combination. Company B expects to continue to use the intellectual property in the sale of currently marketed products as well as in identified future R&D activities.

Question: How should Company B account for the acquisition of the patented intellectual property?

Solution

Company B would not assign the acquired patent an indefinite life upon acquisition because it is not solely being used for the purpose of an ongoing R&D. The patent would be accounted for under ASC 350-30-25 and treated as a single intangible asset or grouped with other intangible assets associated with the currently marketed product and would be amortized over a finite life.

If the patent was solely used in ongoing R&D, the AICPA concluded that it may be appropriate to aggregate the patent with other intangible assets used in the R&D activities and capitalize it as an indefinite lived IPR&D asset.

Relevant guidance

ASC 350-30-35-17A: Intangible assets acquired in a business combination... that are used in research and development activities (regardless of whether they have an alternative future use) shall be considered indefinite lived until the completion or abandonment of the associated research and development efforts...

The AICPA’s Accounting and Valuation Guide on acquired intangible assets used in R&D activities a makes a distinction between complete and incomplete intangible assets used in R&D. Completed intangible assets acquired in a business combination to be used in R&D activities lack the necessary characteristic of being incomplete to be recorded as IPR&D. As a result, the AICPA concluded that these assets should be accounted for in accordance with their nature (e.g., market-related, technology-based). Only intangible assets that are incomplete and used in R&D activities should be accounted for in accordance with ASC 350-30-35-17A (that is, assigned an indefinite useful life upon acquisition).

4-7 Amortization of acquired intellectual property

Background

Company A acquires Company B in a business combination accounted for under ASC 805. As part of the business combination, Company A acquires the intellectual property of Company B that meets the criteria for separate recognition of an intangible asset apart from goodwill. The intellectual property acquired by Company A does not represent IPR&D.

Question: When should Company A begin amortizing the acquired intellectual property, what factors should be considered in determining the amortization period, and how should the costs be classified in the income statement?

Solution

Amortization of intangible assets should begin on the date the asset is available for its intended use, which is generally the acquisition date.

To determine the useful life, in addition to the factors in ASC 350-30-35-3, Company A should consider industry-specific factors, such as the following:

a.    Duration of the patent right or license of the product

b.    Redundancy of a similar medication/device due to changes in market preferences

c.    Unfavorable court decisions on claims related to product liability or patent ownership

d.    Regulatory decisions over patent rights or licenses

e.    Development of new drugs treating the same disease

f.     Changes in the environment that make the product ineffective (e.g., a mutation in the virus that is causing a disease, which renders it stronger)

g.    Changes or anticipated changes in participation rates or reimbursement policies of insurance companies

h.    Changes in government reimbursement or policies (e.g., Medicare, Medicaid) for drugs and other medical products

None of the above factors should be considered more presumptive than any other, and companies should consider all the facts and circumstances when estimating an asset’s useful life. Companies should also evaluate the remaining useful lives of their intangible assets each reporting period to determine whether events and circumstances warrant revisions to the estimated useful lives. A change in the estimated useful lives of intangible assets is considered a change in an accounting estimate and should be accounted for prospectively in the period of change and future periods.

Income statement classification of an intangible asset’s amortization expense should reflect the nature of the asset. If Company A expects to utilize the technology to support the commercialization process or to manufacture goods, the presumption is that amortization would be recorded as part of cost of goods sold.

Relevant guidance

Pursuant to ASC 805-20-55-2 through 55-4, an intangible asset that meets the contractual-legal criterion or separability criterion is considered identifiable and is recognized at fair value using the market participant framework contained in ASC 820, Fair Value Measurement. Intangible assets are amortized over their estimated useful lives. If the precise length is unknown, intangible assets should be amortized over a company’s best estimate of the assets’ useful life.

ASC 350-30-35-2: The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity...

ASC 350-30-35-3: The estimate of the useful life of an intangible asset to an entity shall be based on an analysis of all pertinent factors, in particular, all of the following factors with no one factor being more presumptive than the other:

a.      The expected use of the asset by the entity.

b.      The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate.

c.      Any legal, regulatory, or contractual provisions that may limit the useful life. The cash flows and useful lives of intangible assets that are based on legal rights are constrained by the duration of those legal rights. Thus, the useful lives of such intangible assets cannot exceed the length of their legal rights and may be shorter.

d.      The entity’s own historical experience in renewing or extending similar arrangements, consistent with the intended use of the asset by the entity, regardless of whether those arrangements have explicit renewal or extension provisions. In the absence of that experience, the entity shall consider the assumptions that market participants would use about renewal or extension, consistent with the highest and best use of the asset by market participants, adjusted for entity-specific factors in this paragraph.

e.      The effects of obsolescence, demand, competition, and other economic factors (such as the stability of the industry, known technical advances, legislative action that results in an uncertainty or changing regulatory environment, and expected changes in distribution channels)

f.       The level of maintenance expenditures required to obtain the expected future economic benefits from the asset (for example, a material level of required maintenance in relation to the carrying amount of the asset may suggest a very limited useful life). As in determining the useful life of depreciable tangible assets, regular maintenance may be assumed but enhancements may not.

If an income approach is used to measure the fair value of an intangible asset, Company A should consider the period of expected cash flows used to measure fair value adjusted as appropriate for the entity-specific factors noted above.

The classification of amortization expense should generally be determined based on the asset’s intended use and recorded in the income statement accordingly.

4-8 Cash flow presentation of up-front licensing fee (updated August 2019)

Background

Company A pays Company B a $3 million non-refundable fee to license Company B’s know-how and technology related to a compound in the research stage.

Company A determines that this meets the definition of an asset acquisition and the license has no alternative future use. Company A expenses the $3 million as incurred as in-process R&D costs.

Question: What is the appropriate presentation of the up-front licensing fee in the statement of cash flows?

Solution

Company A should consider the nature of the underlying cash flow in determining its classification. In general, Company A should classify the cash outflow based on what is likely to be the predominant use of cash. Given that the nature of this cash flow has aspects of more than one class of cash flows as well as the lack of authoritative guidance in this area, we believe that classification in either operating or investing is acceptable.

Company A should consistently apply their classification conclusion to similar transactions.

Relevant guidance

ASC 230-10-45-22: In the absence of specific guidance, a reporting entity shall determine each separately identifiable source or each separately identifiable use within the cash receipts and cash payments on the basis of the nature of the underlying cash flows, including when judgment is necessary to estimate the amount of each separately identifiable source or use. A reporting entity shall then classify each separately identifiable source or use within the cash receipts and payments on the basis of their nature in financing, investing, or operating activities.

ASC 230-10-45-22A: In situations in which cash receipts and payments have aspects of more than one class of cash flows and cannot be separated by source or use... the appropriate classification shall depend on the activity that is likely to be the predominant source or use of cash flows for the item.

ASC 230-10-45-13C: All of the following are cash outflows from investing activities...Payments at the time of purchase or soon before or after purchase to acquire property, plant, and equipment and other productive assets...

ASC Master Glossary: Operating activities include all transactions and other events that are not defined as investing or financing activities (see paragraphs 230-10-45-12 through 45-15). Operating activities generally involve producing and delivering goods and providing services. Cash flows from operating activities are generally the cash effects of transactions and other events that enter into the determination of net income.

AICPA’s Accounting and Valuation Guide on acquired intangible assets used in R&D activities - Q&A 5.12:

Question 1: How should an acquiring entity classify in its statement of cash flows an R&D charge associated with the costs of IPR&D projects acquired as part of an asset acquisition that have no alternative future use?

Answer: Best practices suggest that an acquiring entity should report its cash acquisition of assets to be used in R&D activities as an investing outflow in its statement of cash flows. In this regard, an acquiring entity should treat assets acquired to be used in R&D activities similar to how it reports other acquired assets in the statement of cash flows. Although acquired IPR&D may lack an alternative future use and, therefore, would be expensed immediately, it is still an asset for cash flow statement purposes.

When arriving at cash flows from operating activities under the indirect method of reporting cash flows, best practices suggest that an acquiring entity should add back to net income the costs of assets acquired to be used in R&D activities that are charged to expense. That adjustment is necessary to eliminate from operating cash flows those cash outflows of assets acquired to be used in R&D activities that are reflected in investing activities.

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Laura Robinette

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

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