Contingent

Contingent

Contingent is a word used regularly in IFRS Standards and it is used in a rather normal way, most of the times a s contingent being dependent on. Here are the IFRS Standards in which contingent is used and in which context.

IFRS 3 Business combinations

Buyer’s accounting for royalties and milestones payable to a seller in a business combination

Acquisitions and divestitures have been headline news in the pharmaceutical and life sciences industry lately. With expiring patents on blockbuster products and downward pricing pressure, many companies have increased their M&A activity and turned to acquisitions to expand research pipelines in order to fuel innovation. In addition, companies have also looked to sell businesses or assets as part of R&D portfolio decisions to streamline operations and focus their efforts on faster growing areas of the business.

A common theme in acquisitions is that part of the purchase consideration may be in the form of future payments, such as royalties (i.e., the buyer has an obligation to make future royalty payments to the seller) or milestones. Payments related to these contingent obligations are often triggered by regulatory approval of in-process research and development (IPR&D) projects, or based on future performance measures, such as a percentage of sales.

Because many acquisitions or licenses of intellectual property, particularly those still in development, include milestone or royalty payments to the seller/licensor, the accounting and valuation of those contingent payments is often complex.

Contingent consideration in a business combination

Under IFRS and US GAAP, in a business combination, contingent consideration represents an obligation of the acquirer to transfer additional assets or equity interests to the selling shareholders if future events occur or conditions are met.

In evaluating whether future obligations to the selling shareholders represent contingent consideration, it is important to determine whether the payments represent part of the consideration transferred to acquire the business or represent a transaction separate from the business combination. Understanding the nature of the obligation, why the obligation exists, and whether there are other assets or benefits the buyer is receiving, will play a part in this analysis.

Generally, in a business combination, future royalty or milestone payments owed to the seller are treated as contingent consideration. The buyer should classify contingent consideration as a liability, an asset, or equity depending on its terms. All contingent consideration arrangements are initially measured at fair value on the acquisition date.

Contingent consideration that is classified as a liability or asset is remeasured to fair value at each reporting date, with changes included in the income statement in the post-combination period until the uncertainty is resolved. Contingent consideration that is classified as equity is not remeasured, and is accounted for within equity upon settlement.

Most contingent consideration arrangements in the pharmaceutical and life sciences industry are classified as liabilities, including both those settled in cash and certain equity-settled arrangements.

Assumed contingent consideration

An assumed contingent consideration arrangement is accounted for as an assumed liability (or in some instances, an asset) of the acquired business under IFRS. As these arrangements would almost always be established by a contract, they would fall within the scope of IAS 32 and IFRS 9 and be recognized at fair value on the acquisition date.

Subsequently, they would be remeasured at fair value, with changes in value reflected in the income statement. The IASB concluded that such pre-existing arrangements do not constitute contingent consideration under IFRS 3 because the consideration does not arise from the current transaction between the acquirer and the former owners of the acquiree.

Compensation

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

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

IFRIC 12 – Service Concession Arrangements

IFRIC 12 is concerned with the accounting by private sector operators for “public-to-private” service concession arrangements (which are also know by a variety of other titles, including “service concession” “build-operate-transfer” or “rehabilitate-operate-transfer” arrangements). These arrangements typically involve a private sector operator constructing (or upgrading) the infrastructure used to provide the public service, and then operating and maintaining the infrastructure for a specified period of time.

However, the Interpretation does not apply to all such arrangements. Its scope is limited to public-to-private service concession arrangements in which:

• the grantor controls the use of the infrastructure; and
• the grantor controls (through ownership, beneficial entitlement or otherwise) any significant residual interest in the infrastructure at the end of the term of the arrangement.

Accounting model

The key issue dealt with by the Interpretation is the accounting for the operator’s rights over the infrastructure.

The first principle established in IFRIC 12 is that, under arrangements meeting the ‘grantor control’ criteria discussed above, the infrastructure should not be recognised as property, plant and equipment of the operator because the operator does not control the use of the infrastructure. Rather, the right that the operator receives is the right to operate the infrastructure for the purpose of providing the public service on behalf of the grantor. On the basis of the economic benefits to which it is entitled under the arrangement, the operator must determine whether the nature of the asset it receives is a financial asset or an intangible asset (or a mixture of both of these).

The requirements of IFRIC 12 regarding the nature of the asset to be recognised can be summarised as follows:

The detailed accounting treatment under each of these models is discussed in this section.

IFRS 16 Leases

Lease Options to Extend or Terminate

As noted above, appropriate consideration of how likely a lessee is to exercise its right to extend or terminate a lease is crucial in determining the correct lease term.

The analysis should consider all relevant facts and circumstances that create an economic incentive for the lessee to exercise the option, or vice versa. This includes considering any expected changes in facts and circumstances from the start of the lease until the exercise date of the option.

A lessee is more likely to exercise an extension option or not exercise a termination option the shorter the non-cancellable period is. This is due to the higher cost associated with obtaining a replacement asset for the shorter non-cancellable period.

In addition, a lessee is likely to exercise an extension option or not exercise a termination option when the extension or termination option is combined with one or more other contractual features (e.g. a residual value guarantee) where the lessee guarantees the lessor a return that is substantially the same regardless of whether the option is exercised.

The following sample questions will assist the entity in their assessment:

• Are terms and conditions favorable or unfavorable to the lessee for the optional periods compared to market rates (amount of fixed, variable and/or contingent payments in optional periods; any penalties; etc.)?
• Will the lessee need to make significant leasehold improvements to the underlying asset over the lease term?
• Are there significant costs related to the termination of the lease? (e.g. negotiation, relocation, identifying another underlying asset suitable for the lessee’s needs, integrating a new asset into the lessee’s operations, or termination penalties and similar costs);
• How important is the underlying asset to the lessee’s operations? (is it specialized?, what is the availability of suitable alternatives?); and
• Are there conditions that must be met in order for the option to be exercised? If so, what is the likelihood that those conditions will be met?
• Does the lessee have a past practice of exercising extension options or not exercising termination options and the economic reasons relating to past practice is still relevant?

IAS 19 Employee benefits – Measurement

Shared risk pension plan  – Performance targets or other criteria

Under IAS 19, actuarial assumptions include the best estimate of the effect of performance targets or other criteria. For example, the terms of a plan may state that it will pay reduced benefits or require additional contributions from employees if the plan assets are insufficient. These kinds of criteria are reflected in the measurement of the defined benefit obligation, regardless of whether the changes in benefits resulting from the criteria either being or not being met are automatic or are subject to a decision by the entity, by the employee, or by a third party such as the trustee or administrators of the plan. (IAS 19.88(c))

The IASB is aiming to clarify that risk-sharing features such as performance targets should be incorporated into the determination of the best estimate of the defined benefit obligation. In the IASB’s view, features in a plan that result in sharing the risks between the entity and the plan participants (e.g. sharing the benefit of a surplus or the cost of a deficit) do not change the fact that the plan is a defined benefit plan. It is not a defined contribution plan, since the entity is exposed to some risk. However, the shared-risk features (including any conditional indexation features) would be taken into consideration when determining the best estimate of the defined benefit obligation. (IAS 19.BC144, 145)

Careful consideration of the substance of the arrangement

It is important to ensure that there is substance to the risk-sharing arrangement before the entity’s defined benefit obligation is reduced to reflect this sharing of risk.

Case – shared risk pension plan

Sponsor A provides to its employees a shared risk pension plan with the following characteristics: Benefits granted to employees are contingent on the funding level (plan assets divided by defined benefit obligation). If the funding level is above 100 percent, then the benefits are increased and if the funding level is less than 100 percent, then the benefits are decreased, though not below a specified minimum level. New employees are informed that every benefit granted is contingent on funding levels. The actuarial assumptions used in the measurement of the defined benefit obligation include the best estimate of the effect of the funding criteria.

IFRS 15 Revenue from contracts with customers

Variable consideration

The revenue standard requires an entity to estimate the amount of variable consideration to which it will be entitled.

IFRS 15.50 – If the consideration promised in a contract includes a variable amount, an entity shall estimate the amount of consideration to which the entity will be entitled in exchange for transferring the promised goods or services to a customer.

Variable consideration is common and takes various forms, including (but not limited to) price concessions, volume discounts, rebates, refunds, credits, incentives, performance bonuses, and royalties. An entity’s past business practices can cause consideration to be variable if there is a history of providing discounts or concessions after goods are sold.

Consideration is also variable if the amount an entity will receive is contingent on a future event occurring or not occurring, even though the amount itself is fixed. This might be the case, for example, if a customer can return a product it has purchased.

The amount of consideration the entity is entitled to receive depends on whether the customer retains the product or not (here is a discussion of return rights).

Similarly, consideration might be contingent upon meeting certain performance goals or deadlines. The amount of variable consideration included in the transaction price may be constrained in certain situations, as discussed at here.

No “contingent revenue cap”

An entity should allocate the transaction price to all of the performance obligations in the arrangement, irrespective of whether additional goods or services need to be provided before the customer pays the consideration. For example, a wireless phone entity enters into a two-year service agreement with a customer and provides a free mobile phone, but does not require any upfront payment. The entity should allocate the transaction price to both the mobile phone and the two-year service arrangement, based on the relative standalone selling price of each performance obligation, despite the customer only paying consideration as the services are rendered.

Concerns about whether the customer intends to pay the transaction price are considered in either the collectibility assessment (that is, whether a contract exists) or assessment of customer acceptance of the good or service. Refer to IFRS 15 Step 1 for further information on collectibility and for further information on customer acceptance clauses.

Performance obligations satisfied at a point in time – Customer has accepted the asset

A customer acceptance clause provides protection to a customer by allowing it to either cancel a contract or force a seller to take corrective actions if goods or services do not meet the requirements in the contract. Judgment can be required to determine when control of a good or service transfers if a contract includes a customer acceptance clause.

Customer acceptance that is only a formality does not affect the assessment of whether control has transferred. An acceptance clause that is contingent upon the goods meeting certain objective specifications could be a formality if the entity has performed tests to ensure those specifications are met before the good is shipped.

Management should consider whether the entity routinely manufactures and ships products of a similar nature, and the entity’s history of customer acceptance upon receipt of products. The acceptance clause might not be a formality if the product being shipped is unique, as there is no history to rely upon.

An acceptance clause that relates primarily to subjective specifications is not likely a formality because the entity cannot ensure the specifications are met prior to shipment. Management might not be able to conclude that control has transferred to the customer until the customer accepts the goods in such cases. A customer also does not control products received for a trial period if it is not committed to pay any consideration until it has accepted the products. This accounting differs from a right of return, as discussed here, which is considered in determining the transaction price.

Customer acceptance, as with all indicators of transfer of control, should be viewed from the customer’s perspective. Management should consider not only whether it believes the acceptance is a formality, but also whether the customer views the acceptance as a formality.

Contractual minimums related to in-substance sales- or usage-based royalties

Management will need to consider the nature of any variable consideration promised in exchange for a license of IP to determine if, in substance, the variable consideration is a sales- or usage-based royalty. Examples include arrangements with milestone payments based upon achieving certain sales or usage targets and arrangements with an upfront payment that is subject to “claw back” if the licensee does not meet certain sales or usage targets.

The sales- or usage-based royalty exception does not apply to fees that are fixed and are not contingent upon future sales or usage. Some arrangements include both a fixed fee and a fee that is a sales- or usage-based royalty. Determining the transaction price and pattern of recognition could require judgment in these arrangements.

Non-contingent, fixed fees are not subject to the sales- or usage-based royalty exception.