Mergers & acquisitions a snapshot Change the way you think about tomorrow s deals

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1 Mergers & acquisitions a snapshot Change the way you think about tomorrow s deals Stay ahead of the accounting and reporting standards for M&A 1 April 23, 2013 What's inside IPR&D accounting the basics... 2 Practical challenges Unit of account...2 Core or base technology...3 Impairment... 4 Valuation... 4 In summary... 4 We re in the process of acquiring a company with significant in-process research and development (IPR&D) activities. What's next? Buyers often look for potential targets that may be in the process of performing research and development for a new product or products. Those in-process research and development (IPR&D) activities can have significant value and, therefore, drive a significant component of the acquisition price. These types of deals are particularly common in the software, technology, and pharmaceutical and life sciences industries. The M&A Standards significantly changed the accounting for acquired IPR&D. It used to be valued as part of the acquisition and immediately charged to expense, just like ongoing research and development costs. But today acquired IPR&D is generally considered an indefinite-lived asset. This, along with changes in the fair value standards governing how IPR&D is valued, has led to evolving practice with respect to the initial valuation of IPR&D and its subsequent accounting. In fact, a task force of the American Institute of Certified Public Accountants (AICPA) is in the process of updating its accounting and valuation guide related to IPR&D. The task force s guidance, while not mandatory, can be helpful in applying the M&A Standards. This edition of Mergers & acquisitions a snapshot, provides an overview of the accounting rules and a glimpse into some of the issues companies face in the accounting and valuation of acquired IPR&D. 1 Accounting Standards Codification 805 is the US standard on business combinations, and Accounting Standards Codification 810 is the US standard on noncontrolling interests (collectively the "M&A Standards"). M&A snapshot 1

2 IPR&D accounting the basics Under the previous accounting rules, acquired IPR&D projects that were substantive but incomplete at the date of the acquisition were recorded at fair value and generally expensed immediately. Under the M&A Standards, 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 until the completion or abandonment of the associated research and development efforts. If abandoned, the carrying value of the IPR&D asset is expensed. Once the associated research and development efforts are completed, the carrying value of the acquired IPR&D is reclassified as a finite-lived asset and is amortized over its useful life. The requirement to recognize acquired IPR&D in an acquisition as an indefinite-lived intangible asset does not apply to incremental costs incurred on the IPR&D project after the acquisition date. These incremental costs continue to be expensed as incurred. Acquired IPR&D refers to an acquired intangible asset used in R&D activities and is distinguished from an acquired tangible asset that is used in R&D activities (e.g., computerized testing equipment) or an acquired intangible asset resulting from R&D activities (e.g., completed projects). These latter items may meet the criteria in the M&A Standards to be recognized as a separately identifiable tangible or intangible asset, but are not treated as an indefinite-lived asset like acquired IPR&D. The following example highlights some of these accounting differences. Example 1 Accounting for acquired IPR&D Facts: Company A is in the pharmaceutical industry and owns the rights to several product (drug compound) candidates. Its only activities consist of research and development that are being performed on the 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, and 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 the acquisition of a business under the M&A Standards. Analysis: Company B will continue to measure the acquired IPR&D at its acquisition date fair value but will 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. Incremental research and development costs subsequent to the acquisition would be expensed. Company A also had a product candidate that received FDA approval, but for which it had not yet started production. Any such completed product development (i.e., no longer in-process ) would be recognized as a finite-lived intangible asset at the date of acquisition, separate from the acquired IPR&D. The testing and developing equipment would be separately recognized as tangible assets, measured at fair value, and depreciated over their estimated useful lives. Practical challenges While the concept of capitalizing acquired IPR&D may sound simple, this capitalization requirement has led to many complex and challenging issues, such as determining the appropriate unit of account and the accounting for core technology. The requirement to test the acquired IPR&D intangible asset for impairment raises additional challenges. And, in some cases, the capitalization requirement makes determining whether the initial transaction is the acquisition of an asset or a business more important, as acquired IRP&D in an asset acquisition generally continues to be expensed immediately. Unit of account A company might acquire another company that is pursing completion of an IPR&D project that, if successful, will result in a drug compound for which the acquirer would seek regulatory approval all over the world. In the past, it did not matter whether the acquired IPR&D was a single global asset or multiple assets because the entire acquired IPR&D was expensed upon acquisition. Under the M&A Standards, because of the requirement to capitalize and test the acquired IPR&D asset for impairment, it is important to determine the appropriate unit of account. That determination can be complex and requires considerable judgment depending on the relevant facts and circumstances of each acquisition. When making this determination, companies may consider, among other things, the following factors: M&A snapshot 2

3 Unit of account factors Phase of development of the related IPR&D project(s) Nature of the activities and costs necessary to further develop the related IPR&D project(s) Risks associated with the further development of the related IPR&D project(s) Amount and timing of benefits expected to be derived from the developed asset(s) Expected economic life of the developed asset(s) Whether there is an intent to manage advertising and selling costs for the developed asset(s) separately or on a combined basis Once completed, whether the product would be transferred as a single asset or multiple assets The following example illustrates a scenario where an acquirer might make a determination of whether it acquired a single asset or multiple assets. Example 2 Unit of account Facts: Company C acquired Company D, which is accounted for as an acquisition of a business under the M&A Standards. At the acquisition date, Company D was pursuing completion of an IPR&D project that, if successful, would result in a drug for which Company C would seek regulatory approval in the United States and Japan. This R&D project is in the latter stages of development but is not yet complete. The nature of the activities and costs necessary to successfully develop the drug and obtain regulatory approval for it in the two jurisdictions are not substantially the same. If approved, the respective patent lives are expected to be different as well. In addition, Company C intends to manage advertising and selling costs separately in both countries. Lastly, Company C does not have an intention to transfer the asset as a single asset. Analysis: The acquired IPR&D project would likely be recorded as two separate "jurisdictional" IPR&D assets. While there may be other factors to consider, Company C s assessment may lead it to believe that the development risks, the nature of the remaining activity and costs, the risk of not obtaining regulatory approval, and expected patent lives for the acquired IPR&D are not substantially the same in both countries. Finally, Company C intends to manage the drug separately, including separate advertising and selling costs in each country. Core or base technology When IPR&D involves enhancements to existing technologies, the allocation of value between a proven technology and an unproven (incomplete) research project can be difficult to measure. In the past, core or base technology that may have been used over multiple versions of a product (for instance, in a computer software product) was capitalized as a separate technology-based, finite-lived intangible asset and amortized over its estimated useful life. The AICPA Task Force has proposed that, in light of improved understanding of asset identification and valuation, value that has historically been attributed to core technology should instead be allocated to other identifiable assets, which could include IPR&D. The following example illustrates the concept of core or base technology, as proposed by the AIPCA Task Force. Example 3 Core technology Facts: Company E acquired Company F, which is accounted for as an acquisition of a business under the M&A Standards. At the acquisition date, Company F produced and sold proprietary software as Version 1.0, and was conducting research and development related to significant improvements to Version 1.0 (meaning, Version 1.0 was being modified and partly reused in a new version) that Company F expected to sell as new software, Version 2.0. Company F also believes there is potential for additional enhancements that may be expected to be included in Version 3.0 (Version 3.0 was not yet under development at the date of the acquisition). Analysis: Based on the proposed interpretation by the AICPA Task Force, Company E likely would not recognize a core or base technology asset for the technology present in Version 1.0, even though Version 1.0 will serve as a foundation for subsequent versions of the software (i.e., Version 2.0 and, potentially, Version 3.0). The value would instead be allocated to other identifiable assets. However, the fully developed and commercialized technology represented by 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 would be recognized as an indefinite-lived 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. M&A snapshot 3

4 Impairment During the post-acquisition period until completion or abandonment of acquired IPR&D activities, the related indefinite-lived intangible asset will be subject to impairment testing. This would occur annually or more frequently if events or circumstances (for example, failure to obtain regulatory approval, a competitor releases a superior technology, abandonment of the R&D efforts, etc.) indicate that the asset may be impaired. Companies have the option to first assess qualitatively whether it is necessary to perform the quantitative impairment test. They are not required to calculate the fair value of an indefinite-lived intangible asset unless they determine that it is more likely than not (that is, a likelihood of more than 50 percent) that the asset is impaired. Companies may bypass the qualitative assessment and proceed directly to the quantitative impairment test for any indefinite-lived intangible asset, including an IPR&D asset, in any period. The quantitative impairment test consists of comparing the fair value of the intangible asset with its carrying amount. If the carrying amount of the intangible asset exceeds its fair value, an impairment loss would be recognized equal to that excess. Valuation Under the applicable fair value guidance, acquired IPR&D may be valued under the income, market, or cost approaches. In most cases, an income or cost approach will be used. The market approach typically would not be used because comparable market transactions generally are not available. The cost approach is sometimes used to value acquired IPR&D for early stage projects where the economic benefits are uncertain, significant technological (and other) hurdles remain, and the company would be willing to reproduce the existing efforts. An income approach is more commonly used to value acquired IPR&D for middle and/or late stage IPR&D projects because that approach more closely captures the expected economic benefits from the acquired IPR&D. These benefits could be greater than or less than the cost of developing the acquired IPR&D asset. Under the income approach, various models can be used to value acquired IPR&D, including the multi-period excess earnings method (MPEEM), relief-from-royalty method, and decision tree analysis. The appropriate valuation model depends on specific facts and circumstances. For instance, the MPEEM model might be used when acquired IPR&D is the primary asset expected to generate the cash flows associated with the IPR&D project. The relief-fromroyalty method might be used when the company licenses similar technology or can estimate an appropriate royalty rate for the technology. Companies may use the decision tree analysis when there are contingent outcomes at decision points in the future, such as the results of clinical trials. Additionally, companies must consider the key concepts of the fair value measurement framework, such as market participants and highest and best use. For example, acquired IPR&D that an acquirer does not intend to develop but will be used to defend an acquirer's developed product must still be valued based upon market participant assumptions. In summary Although the M&A Standards are not new, the accounting and valuation of acquired IPR&D continue to be challenging and require significant judgment. While we have highlighted only a few of the issues, companies will want to contemplate these and other accounting and valuation implications early to ensure proper financial reporting for acquired IPR&D. For more information on this publication please contact: John Glynn Valuation Services Leader (646) [email protected] Henri Leveque Capital Markets & Accounting Advisory Services Leader (678) [email protected] Principal authors: Lawrence N. Dodyk US Business Combinations Leader (973) [email protected] Lambert M. Shiu National Professional Services Group Senior Manager (973) [email protected] Richard J. Billovits National Professional Services Group Director (973) [email protected] M&A snapshot 4

5 PwC has developed the following publications related to business combinations and noncontrolling interests, covering topics relevant to a broad range of constituents. 10Minutes on Mergers and Acquisitions for chief executive officers and board members What You Need to Know about the New Accounting Standards Affecting M&A Deals for senior executives and deal Mergers & acquisitions a snapshot a series of publications for senior executives and deal on emerging M&A financial reporting issues Business Combinations and Consolidations the new accounting standards an executive brochure on the new accounting standards A Global Guide to Accounting for Business Combinations and Noncontrolling Interests: Application of U.S. GAAP and IFRS Standards for accounting professionals and deal Dataline : FAS 141(R), Business Combinations for accounting professionals and deal Dataline : FAS 160, Noncontrolling Interests in Consolidated Financial Statements for accounting professionals and deal Dataline : Key Considerations for Implementing FAS 141(R) and FAS 160 for accounting professionals and deal Dataline : Nonfinancial Asset Impairment Considerations for accounting professionals and deal Dataline : Revisions to EITF Topic D-98, Classification and Measurement of Redeemable Securities for accounting professionals and deal Dataline : New Guidance for Acquired Contingencies for accounting professionals and deal Dataline : Accounting for Contingent Consideration Issued in a Business Combination for accounting professionals and deal Dataline : Goodwill Impairment FASB proposes changes to impairment test for accounting professionals and deal Dataline : FASB issues guidance that simplifies goodwill impairment test and allows early adoption for accounting professionals and deal Dataline : Indefinite-lived intangible asset impairment FASB issues guidance that simplifies impairment test and allows early adoption for accounting professionals and deal PwC clients who would like to obtain any of these publications should contact their engagement partner. Prospective clients and friends should contact the managing partner of the nearest PwC office, which can be found at PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.