Acquisitions and disposals – IFRS 3 Pharmaceutical and Life Sciences
Contingent consideration arrangements in acquisitions and disposals are common within the Pharmaceutical and Life Sciences industry as they can be a convenient way of validating a company’s value as well as sharing economic risk between the buyer and the seller.
In this industry, many acquisitions and disposals involve compounds or devices that have not yet received regulatory approval, which inherently increases the risk that the degree of commercial success of what is acquired or sold may not be known at the date of acquisition.
For example, a pharmaceutical company may prefer to pay the seller of a biotech company an upfront amount at the acquisition date and then pay an additional amount if one of the compounds acquired receives regulatory approval or reaches a specified sales target.
The acquirer’s accounting for contingent consideration is outlined in the business combination standards (IFRS 3).
The standard defines consideration transferred by the acquirer to include the acquisition date fair value of contingent consideration. Depending on the terms of the contingent consideration, the acquirer either recognises, at the acquisition date, a liability or equity, at fair value.
Liability-classified contingent consideration is remeasured to its fair value through current period earnings each subsequent reporting period. Equity-classified contingent consideration is not remeasured subsequent to its initial recognition. Liability-classified contingent consideration is more common in practice.
Disposals – Seller accounting for contingent consideration
The focus of this part is to discuss the accounting for contingent consideration from the seller’s perspective.
Contingent consideration agreements generally grant the seller the right to receive cash or other financial assets when 
the contingency is resolved, and therefore meet the definition of a financial asset under IFRS. The financial asset should be included as part of consideration received at the transaction date and should be measured using one of the four measurement categories specified in IFRS 9: Financial assets at “fair value through profit or loss”, held to maturity investments, loans and receivables, or available-for-sale financial assets.
Determining the contingent consideration arrangement’s classification will require judgment and will be based on the specific facts and circumstances of each arrangement. Financial assets resulting from contingent consideration will generally be classified as available for sale because the uncertainty of the cash flows and timing of payments typically preclude classification in the other categories.
The classification dictates how the financial assets are subsequently measured in the financial statements. Available-for-sale assets are subsequently measured at fair value, with changes in fair value recognised through other comprehensive income except for:
- Interest calculated using the effective interest method.
- The present value of any changes in the expected cash flows (discounted at the original effective interest rate). [IFRS 9.B5.4.6]
- Foreign exchange gains and losses on monetary financial assets.
- Impairment.
which are recognised in profit or loss. In practice this often has the effect that most of the change in fair value is recognised in profit or loss with the amounts recognised in OCI being only the effect of discounting at a current rate rather than the original rate. Upon receipt of the payment, any amounts in other comprehensive income are recycled to the income statement.
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Case – Sale of a 100% subsidiary |
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Company A sold its entire controlling stake in wholly-owned Subsidiary B on 1/1/x1. The proceeds of the sale included CU 80 million in cash paid upfront plus a contingent payment of CU 40 million if Subsidiary B’s revenue reached CU 200 million by 12/31/x1. The contingent payment would be due and payable on 12/31/x1. As of the transaction date, the fair value of the contingent payment was estimated to be CU 30 million. The carrying amount of net assets of Subsidiary B on the transaction date was CU 100 million. Subsidiary B’s revenue was CU 275 million by 12/31/x1. For simplicity, this example assumes no income tax impact of the sale. Company A accounted for the contingent consideration arrangement based on the following information:
Assessing the case Company A would record a financial asset at fair value at the transaction date (CU 30 million). As a result, Company A would record a gain of CU 10 million on the transaction date (initial cash payment of CU 80 million + fair value of contingent consideration arrangement asset of CU 30 million – carrying value of net assets of CU 100 million). Subsequently, changes in fair value are recognized as follows:
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Buyers accounting for royalties and milestones payable to a seller in a business combination
There are various complex accounting judgments to consider under IFRS when a company purchases a compound or group of assets that meets the definition of a business and the consideration transferred includes an obligation to pay 
future royalties or milestone payments.
The first key judgment is to evaluate whether the transaction should be accounted for as a business combination or an asset acquisition. These types of transactions can be structured in a variety of ways, including outright acquisitions of legal entities, acquisitions of compounds or groups of assets, or licensing arrangements.
Often, the determination of whether the buyer has acquired an asset or a business is complex and judgmental. The accounting for a business combination varies significantly from the accounting for an asset acquisition, particularly related to the treatment of future royalties or milestone payments and the treatment of IPR&D.
IFRS 3 provides guidance for determining whether the buyer has acquired a business or an asset (or group of assets). Here is the business or asset assessment narrated, regarding the accounting guidance, illustrations, and related implications.
Whether the purchase or license of intellectual property meets the accounting definition of a business is a hot topic, and in many cases, arrangements that on the surface appear to convey only assets include other elements that, when combined, may meet the accounting definition of a business (and therefore are accounted for as a business combination).
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. Here is more information available regarding the contingent consideration.
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