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In brief
A look at current financial
reporting issues
Accounting for fixed consideration in licence
05 April 2018 arrangements in the pharmaceutical and life
sciences industry
Background
IFRS 15, ‘Revenue from contracts with customers’, significantly impacts the
accounting for many companies in the pharmaceutical and life sciences (PLS)
industry. This publication highlights some key impacts regarding the accounting for
certain forms of fixed consideration in licensing arrangements under IFRS 15.

Additional information can also be obtained from PwC’s Global Revenue Guide and
the Pharmaceutical and Life Sciences Revenue publication, available at Inform.

Issue
Licences that provide a right to use intellectual property
A licence granted by a PLS company (the licensor) generally provides the customer
(the licensee) with the right to use, but not to own, the licensor’s intellectual property
(IP). A common example in the PLS industry is a company that ‘out-licenses’ to a
customer the IP that it developed in relation to a drug that has not yet received
regulatory approval. Often, under the terms of the licence, the licensee can further
develop the IP, and manufacture and/or sell the resulting commercialised product.
The licensor typically receives an upfront fee, milestone payments for specific clinical
or other development-based outcomes, and sales-based royalties as consideration for
the licence. Revenue is generally recognised at a point in time for arrangements in
which there is a single performance obligation (that is, the transfer of a ‘right to use’
licence). This publication focuses on arrangements in which the transfer of a ‘right to
use’ licence is the only performance obligation. As a result, the accounting treatment
described here might differ for arrangements in which there are two or more
performance obligations, or those in which there are multiple goods and services
combined into a single performance obligation.

Fees payable in annual instalments

In certain out-licensing transactions, licensors receive annual fees payable by the
licensee on each anniversary of the inception of the contract until the end of the
stated licence term. These fees are sometimes paid for the transfer of additional
distinct goods or services to the customer, or they might be payable to the licensor to
fund its patent maintenance or patent defence efforts. In general, a commitment to
maintain or defend an existing patent would not constitute a distinct good or service,
and so it does not result in a separate performance obligation.

This content is for general information purposes only, and should not be used as a substitute for consultation with
professional advisors.
© 2018 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is
a separate legal entity. Please see www.pwc.com/structure for further details.
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If the ‘right to use’ licence is the only performance obligation in the arrangement,
these annual fees should be recognised at the time when control transfers to the
licensee and the licence term begins. This is because a fixed, non-contingent fee (such
as a fee payable in annual instalments), in exchange for a promised good or service, is
not variable consideration that is contingent on the occurrence or non-occurrence of a
future event. This is likely to result in an acceleration of revenue compared to the
current accounting treatment for this payment type.

Minimum guaranteed royalties

Out-licensing arrangements in the PLS industry might contain minimum royalty
guarantees. The minimum guarantee, in some cases, is negotiated due to uncertainty
about the customer’s performance and its ability to successfully exploit the IP. In
other cases, the minimum guarantee is established as a cash flow management tool,
to provide the licensor with predictable timing of some cash flows under the contract.
The minimum amount could be paid at the beginning of the licence term, or it could
be settled either periodically or at the end of the licence term in the event that the
sales- or usage-based royalties are lower than the guaranteed amount.

Assuming that the minimum royalty guarantee is binding and not contingent on the
occurrence or non-occurrence of a future event (such as regulatory approval), it
constitutes fixed consideration that should be recognised at the time when the
company transfers control to the licensee and the licence term begins. This would be
the case irrespective of whether the minimum guarantee is payable upfront, over
time, or at the end of the licence term. However, any royalty amounts above the
minimum guarantee should be recognised when the subsequent sale or usage has
occurred.

Recognising the minimum guarantee amount upfront is likely to result in an

acceleration of revenue compared to the current accounting treatment for this type of
arrangement.

Refer to TRG Memo No. 58, Sales-Based or Usage-Based Royalty with Minimum
Guarantee for further details on this topic.

Related key judgements

The following are key judgements that companies will need to make when accounting
for delayed fixed consideration.

Collectability
A company will need to determine, at the beginning of an arrangement, whether it is
probable that it will collect the consideration to which it is entitled. The assessment
must reflect both the customer’s ability and intent to pay as amounts become due,
and it would include an evaluation of all elements of the transaction price, including
delayed fixed consideration. Importantly, if the company concludes that collection is
not probable, it is not permitted to recognise revenue related to the arrangement until
certain criteria are met. Specifically, revenue cannot be recognised unless the
consideration received is non-refundable and either the contract has been terminated
or the company has no obligation to transfer additional goods or services. A company
that concludes that collection is not probable is required to continue to reassess this
conclusion throughout the term of the arrangement.

Determining the contract term

It is important for companies to evaluate the contract term, in order to determine the
period of time during which both parties have enforceable rights and obligations
This content is for general information purposes only, and should not be used as a substitute for consultation with
professional advisors.
© 2018 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is
a separate legal entity. Please see www.pwc.com/structure for further details.
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under the contract. This could impact the determination of the transaction price and
recognition of revenue; that is, it will dictate the amount of fees payable in annual
instalments or minimum guaranteed royalties to recognise on an accelerated basis
under IFRS 15 when compared to current practice.

Companies will be required to assess whether a contract is cancellable when making

this determination and, if so, whether there is a substantive termination penalty in
the event that the contract is cancelled. We believe that termination penalties could
take various forms, including cash payments or the forfeiture of a valuable right to the
licensed IP on cancellation without refund of amounts paid for such rights.
Significant judgement might be involved in assessing whether forfeiture of a right to
IP is substantive in the context of the arrangement.

A contract that can be cancelled without a substantive termination penalty only has
enforceable rights and obligations for the period that is non-cancellable. Accordingly,
the transaction price would exclude fees that the customer could avoid paying by
cancelling the contract (for example, certain delayed fixed payments). Companies will
also need to assess, in this situation, whether the contract contains a material right
related to future optional purchases.

Significant financing component

Given the long-term nature of these arrangements and the existence of fixed
consideration payable on a delayed basis, companies in the PLS industry will need to
evaluate the timing of these payments relative to the transfer of control of the licensed
IP, in order to determine if a significant financing component exists. There might be a
significant financing component, since cash will often be received many years in
arrears of performance. If so, the initial amount of revenue recognised on the transfer
of control of the licence should be discounted for the time value of money, and a
portion of the consideration received (or receivable) should be recognised as interest
income (rather than revenue).

Impact of adoption
Companies should be mindful that the adoption method selected (that is, full
retrospective or modified retrospective) will impact a company’s ability to present
these accelerated amounts as revenue in the income statement for contracts that were
entered into, and performance obligations that were satisfied, before the adoption of
IFRS 15.

Illustrative examples
Example 1
In 2017, company A entered into a six-year arrangement to transfer a licence that
provides the right to use IP in exchange for a non-refundable upfront fee of $500
million and an additional $200 million ($40 million per year) payable in five equal,
annual instalments from 2018 to 2022. There are no other performance obligations in
the contract, and the company has concluded that (1) collection of the consideration
is probable, and (2) there is a substantive termination penalty in the event that the
customer cancels the contract. Under IAS 18, company A recognised the non-
refundable upfront fee of $500 million as revenue in 2017.

In evaluating the impact of adopting IFRS 15, company A determines that the
contract term is equal to the stated term of six years, due to the existence of a
substantive termination penalty for early cancellation. It also concludes that a
significant financing component exists. Specifically, at the date of adoption of IFRS

This content is for general information purposes only, and should not be used as a substitute for consultation with
professional advisors.
© 2018 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is
a separate legal entity. Please see www.pwc.com/structure for further details.
inform.pwc.com

15, the present value of the five annual instalments of $40 million, at the licensee’s
borrowing rate of 5%, equals $173 million.

Company A adopts IFRS 15 on 1 January 2018, using the modified retrospective

transition method. It is not applying the transition practical expedient which permits
an entity not to restate completed contracts. Company A is required to accelerate the
recognition of the $173 million payable in annual instalments, since the underlying
performance obligation (that is, the transfer of a ‘right to use’ licence) was fully
satisfied prior to adoption. However, given that company A adopted using the
modified retrospective transition method, the entire adjustment (that is, $173
million) will be reflected in the cumulative effect of initially applying IFRS 15 as an
adjustment to the opening balance of retained earnings (or other appropriate
component of equity) on 1 January 2018. Company A will also recognise $27 million
of interest income over the remainder of the contract term.

Example 2
Company B entered into a ten-year arrangement in 2016 to transfer a licence to a
drug compound ready for commercial sale. There are no other performance
obligations in the contract. In addition to a $50 million upfront fee, company B is
entitled to royalties equal to 5% of commercial sales of the drug during the ten-year
licence term. The arrangement includes a total minimum guarantee of $100 million
in royalties over the licence term, which is settled and payable at the end of the ten-
year term, to the extent that some or all of the minimum guaranteed royalties have
not been received. The company concludes that collection of the consideration is
probable.

Company B determines that the contract term is equal to the stated term of ten years,
due to the existence of a substantive termination penalty for early cancellation.
Company B also concludes that a significant financing component does not exist. This
is because the timing of payment of the $100 million minimum guarantee will vary
based on the licensee’s sales of the drug.

Company B adopts IFRS 15 on 1 January 2018, using the full retrospective transition.
It is not applying the transition practical expedient which permits an entity not to
restate completed contracts. Company B is required to accelerate the recognition of
the $100 million minimum guaranteed royalties, since the underlying performance
obligation (that is, the transfer of a ‘right to use’ licence) was fully satisfied prior to
adoption. The entire adjustment (that is, $100 million) will be presented as revenue
on the income statement in 2016, given that company B used the full retrospective
transition method. The entire adjustment would have been recognised as an
adjustment to the opening balance of retained earnings (or other appropriate
component of equity) on 1 January 2018 if company B had adopted IFRS 15 using the
modified retrospective approach.

The amount of any royalties earned in excess of the minimum guarantee will be
recognised in accordance with the royalties exception in IFRS 15 (that is, when the
subsequent sale or usage has occurred).

Questions
PwC clients that have questions about this In brief should contact their engagement
partners. Engagement teams that have questions should contact: Peter Kartscher
(peter.kartscher@il.pwc.com), Ruth Preedy (ruth.e.preedy@pwc.com) or Andrea
Allocco (a.allocco@pwc.com).

This content is for general information purposes only, and should not be used as a substitute for consultation with
professional advisors.
© 2018 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is
a separate legal entity. Please see www.pwc.com/structure for further details.