Business vs. Asset In Practice Potential Impacts of ASU , Clarifying the Definition of a Business

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1 Business vs. Asset In Practice Potential Impacts of ASU , Clarifying the Definition of a Business Jeff Ellis (Deloitte) & Tim Kocses (Bristol-Myers Squibb)

2 Current GAAP What is a Business and Why Does It Matter? Copyright 2017 Deloitte Development LLC. All rights reserved. 2

3 What Is a Business? Current Definition A business is an integrated set of assets and activities capable of being managed to provide a return to its owners. Businesses consist of (1) inputs (e.g., assets, resources), (2) processes (e.g., systems, standards, or protocols) applied to those inputs, that are capable of creating (3) outputs (e.g., economic benefits, such as revenues or lower costs). [ASC ] A business need not include all of the inputs or processes that the seller used in operating that business if market participants are capable of acquiring the business and continuing to produce outputs, for example, by integrating the business with their own inputs and processes. [ASC ] Generally the acquired set of activities and assets must have at least some inputs and processes in order to be considered a business Missing inputs or processes can be readily acquired without significant delay or effort by a market participant Does not need to be a legal entity Outputs do not need to be present at the acquisition date (e.g., development stage entities can be businesses) Copyright 2017 Deloitte Development LLC. All rights reserved. 3

4 What Is a Business? PhRMA White Paper Members of PhRMA drafted and shared with the FASB Staff a white paper that: Highlighted the challenges encountered when interpreting the current authoritative literature regarding the definition of a business. Provided interpretations the group believes are applicable in the life sciences industry as well as the application of these interpretations in practice via examples. Suggested modifications to the current authoritative literature regarding the definition of a business Members of PhRMA viewed the following considerations as particularly important: Phase of development and the meaning of capable of from a market participant s viewpoint Know-how whether an input or a process Contemporaneous arrangements whether considered part of acquired set of assets Employees whether an acquired process Continuing revenue stream whether a business Copyright 2017 Deloitte Development LLC. All rights reserved. 4

5 Why Does It Matter? Acquisition Accounting Differences Contingent Consideration IPR&D Asset Typically not recognized until the contingency is resolved Expensed as incurred unless it has an alternative future use Business Recognized at acquisition date fair value with changes in estimate (that are not measurement period adjustments) recognized through earnings after the acquisition date Measured at fair value and recognized as an indefinite-lived intangible asset until completion or abandonment of the project. Transaction costs Capitalized Expensed Initial measurement Goodwill/Bargain Purchase Cost is allocated on a relative fair value basis Goodwill/Bargain purchases are not recognized and allocated on a relative basis to assets and liabilities Fair value Goodwill recognized as an asset; Bargain purchase recognized immediately in earnings Copyright 2017 Deloitte Development LLC. All rights reserved. 5

6 Why Does It Matter? Derecognition Differences Control Asset (Subtopic ) Business (Topic 805) Control assessed pursuant to the new revenue standard Consolidation guidance determines control Variable Consideration Existence of a Contract Goodwill allocation Measurement of Retained Interest in noncontrolling investment Included in transaction price subject to the constraint on variable consideration in Topic 606 Must evaluate Topic 606 guidance including collectibility Disposals do not impact goodwill unless the reporting unit is sold Tentative Board Decision on Phase 2: retained interest measured at carryover basis Policy election: 1) Recognize at fair value; or 2) Recognize as contingency is resolved (ASC 450) No such consideration Goodwill is allocated to disposals that comprise a reporting unit Fair value Copyright 2017 Deloitte Development LLC. All rights reserved. 6

7 Why Does It Matter? Acquisition Accounting and Derecognition Differences Accounting for transactions as business combinations and divestitures is significantly different than asset acquisitions and divestitures As a result, it is important to determine whether a business or an asset or group of assets is acquired or divested. A business is defined in ASC 805 Typical inputs include long-lived assets (including intangible assets or rights to use longlived assets), intellectual property and the ability to obtain access to required resources. Typical processes include strategic, operational and resource management processes that are typically documented or evident through an organized workforce. We consider all of the above factors when determining whether a business was acquired (or divested) as well as the compound's development phase if no commercial products are involved. For example, in evaluating our acquisitions of Cormorant and Padlock in 2016, Cardioxyl and Flexus in 2015 and ipierian in 2014, we concluded that no significant processes were transferred to us, thus the transactions were accounted for as asset acquisitions. As a result, the amounts allocated to the lead investigational compounds were expensed and not capitalized. In addition, contingent consideration from potential development, regulatory, approval and sales-based milestones and sales-based royalties were not included in the purchase price... Similarly, in evaluating our divestitures of our investigational HIV medicines business and the business comprising the alliance with Reckitt in 2016, Erbitux*, Ixempra* and the businesses comprising the alliances with The Medicines Company and Valeant Pharmaceuticals International, Inc. in 2015, and our diabetes business to AstraZeneca in 2014 we concluded that all necessary inputs and processes were transferred, and consequently the transactions were accounted for as sales of businesses, which resulted in the allocation of goodwill ($98 million in 2016, $73 million in 2015 and $600 million in 2014) to the carrying value of the businesses in determining the gain on sale. Contingent proceeds related to divestitures are not recognized until realized. Copyright 2017 Deloitte Development LLC. All rights reserved. 7

8 Why Does It Matter? The Business Scope Exception and Consolidation of VIEs A business, as defined in ASC 805, need not be evaluated under the variable interest entity consolidation model if the business scope exception applies If the business scope exception does not apply and the entity is a VIE and is required to be consolidated, the accounting upon consolidation differs based on whether the entity meets the definition of a business If a VIE meets the definition of a business, the primary beneficiary s initial consolidation of the VIE must be accounted for as a business combination under ASC 805 If a VIE does not meet the definition of a business, the primary beneficiary s initial measurement of the VIE s assets (except goodwill) and liabilities would follow the measurement guidance of ASC 805. However, the primary beneficiary is prohibited from recognizing goodwill and would, instead, recognize a loss. Copyright 2017 Deloitte Development LLC. All rights reserved. 8

9 Why Does It Matter? The Business Scope Exception and Consolidation of VIEs In October 2014, BMS entered into an agreement with F-Star. The agreement provides BMS with an exclusive option to purchase F-Star and its Phase I ready lead asset FS102, a targeted therapy in development for the treatment of breast and gastric cancer among a well-defined population of HER2-positive patients. BMS paid $50 million to F-Star and its shareholders in 2014 in consideration for the option grant and certain licensing rights (included in research and development expenses) and is responsible for conducting and funding the development of FS102. The option is exercisable at BMS's discretion and expires upon the earlier of 60 days following obtaining proof of concept or June An additional $100 million will be payable upon the exercise of the option plus an additional aggregate consideration of up to $325 million for contingent development and regulatory approval milestone payments in the U.S. and Europe. BMS is not obligated to provide any additional financial support to F-Star. F-Star was determined not to be a business as defined in ASC Business Combinations. As a result, contingent consideration was not included in the purchase price and no goodwill was recognized. However, F-Star is a variable interest entity as its equity holders lack the characteristics of a controlling financial interest. BMS was determined to be the primary beneficiary because of both its power to direct the activities most significantly and directly impacting the economic performance of the entity and its option rights described above. Upon consolidation in 2014, noncontrolling interest was credited by $59 million to reflect the fair value of the FS102 IPRD asset ($75 million) and deferred tax liabilities. Copyright 2017 Deloitte Development LLC. All rights reserved. 9

10 Why Does It Matter? SEC Focus You state that you acquired no significant processes in your April 2014 acquisition of the outstanding shares of ipierian, Inc. Please provide us your analysis supporting this conclusion and that this was not an acquisition of a business Also provide us a similar analysis with respect to your April 2015 acquisition of all of the outstanding shares of Flexus Biosciences, Inc., which is expected to be accounted for as an asset acquisition as is disclosed in Note 18 to your financial statements included in your March 31, 2015 Form 10-Q. Copyright 2017 Deloitte Development LLC. All rights reserved. 10

11 Why Does it Matter? Diversity In Practice stakeholders said that analyzing transactions under the current definition is difficult and costly. Those concerns about the definition of a business were the primary issues raised in connection with the Post-Implementation Review Report on [SFAS 141R] Topic 805 does not specify the minimum inputs and processes required for a set to meet the definition of a business. That lack of clarity led to broad interpretations of the definition of a business The definition of a business in GAAP is currently identical to the definition in IFRS. However, the Board observed that although the definition is identical, it does not to appear to be interpreted or applied consistently in practice between jurisdictions that apply GAAP and jurisdictions that apply IFRS - ASU , Clarifying the Definition of a Business Copyright 2017 Deloitte Development LLC. All rights reserved. 11

12 ASU Clarifying the Definition Copyright 2017 Deloitte Development LLC. All rights reserved. 12

13 Clarifying the Definition of a Business Key Provisions Single or Similar Asset Threshold 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. The Board intends for this to be a practical screen At a minimum, to be a business, a set must include an input and a substantive process The Board also decided to provide a framework to assist in this determination The Board decided to remove the requirement that a market participant must be able to replace all the missing elements in order to be a business Outputs should be defined similar to goods or services provided to customers (i.e. focus on revenue) Copyright 2017 Deloitte Development LLC. All rights reserved. 13

14 Clarifying the Definition of a Business Single or Similar Asset Threshold The Board decided on the threshold of substantially all. The comparison of the fair value is made between the single identifiable asset or group of similar assets compared to the gross assets acquired (including goodwill but excluding liabilities, acquired cash/cash equivalents, DTAs and GW associated with DTLs) Comparison may be qualitative or quantitative (paragraph BC19) A single asset is any asset that would be recognized and measured separately in a business combination. The Board did not provide guidance on what is considered similar but provided some guidelines for what cannot be considered similar: Tangible and intangible assets Different major classes of intangible assets Financial and nonfinancial Different major classes of financial assets Different major classes of tangible assets Identifiable assets within the same major asset class that have significantly different risk characteristics Copyright 2017 Deloitte Development LLC. All rights reserved. 14

15 Clarifying the Definition of a Business Single or Similar Asset Threshold (continued) Six Part Model to Apply Step 1 : 1. Define all the identifiable assets in the acquired set 2. Combine any identifiable assets that meet exceptions in paragraph B (below) into a single identifiable asset 1. A tangible asset that is attached to and cannot be physically removed and used separately form another tangible asset (or an intangible asset representing the right to use a tangible asset) without incurring significant cost or significant diminution in utility or fair value to either asset (for example land and building) 2. In-place lease intangibles, including favorable and unfavorable intangible assets or liabilities, and the related leased assets. 3. Determine whether the remaining assets from Step B are similar assets in accordance with paragraph C (see previous slide for what is not considered similar) 4. Determine the fair value of the gross assets acquired 5. Compare single identifiable asset or group of similar identifiable assets to the fair value of gross assets acquired 6. Is substantially all of the fair value of the gross assets acquired concentrated in a single (group of similar) identifiable asset(s)? Yes The acquired set is not a business No Go to Step 2, Does the acquired set have outputs? Copyright 2017 Deloitte Development LLC. All rights reserved. 15

16 Clarifying the Definition of a Business Single or Similar Asset Threshold Case B: Acquisition of a Drug Candidate Scenario Pharma Co. purchases from Biotech a legal entity that contains the rights to a Phase 3 (in the clinical research phase) compound being developed to treat diabetes (the inprocess research and development project). Included in the in-process research and development project [are] the historical know-how, formula protocols, designs, and procedures expected to be needed to complete the related phase of testing. 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 Pharma Co. first considers the guidance in paragraphs A through 55-5C. Pharma Co. concludes that the in-process research and development project is an identifiable intangible asset that would be accounted for as a single asset in a business combination. Pharma Co. also qualitatively concludes that there is no fair value associated with the clinical research organization contract and the clinical manufacturing organization contract because the services are being provided at market rates and could be provided by multiple vendors in the marketplace. Therefore, all of the consideration in the transaction will be allocated to the in-process research and development project. As such, Pharma Co. concludes that substantially all of the fair value of the gross assets acquired is concentrated in the single in-process research and development asset and the set is not a business. Copyright 2017 Deloitte Development LLC. All rights reserved. 16

17 Clarifying the Definition of a Business Single or Similar Asset Threshold Case B: Acquisition of a Drug Candidate Scenario Pharma Co. purchases from Biotech a legal entity that contains the rights to a Phase 3 compound being developed to treat diabetes (Project 1) and a Phase 3 compound being developed to treat Alzheimer s disease (Project 2). Included with each project are the historical know-how, formula protocols, designs, and procedures expected to be needed to complete the related phase of testing. The legal entity also holds at-market clinical research organization contracts and at-market clinical manufacturing organization contracts associated with each project. Assume that Project 1 and Project 2 have equal fair value. No employees, other assets, or other activities are transferred Pharma Co. concludes that Project 1 and Project 2 are each separately identifiable intangible assets, both of which would be accounted for as a single asset in a business combination. Pharma Co. then considers whether Project 1 and Project 2 are similar assets. Pharma Co. notes that the nature of the assets is similar in that both Project 1 and Project 2 are in-process research and development assets in the same major asset class. However, Pharma Co. concludes that Project 1 and Project 2 have significantly different risks associated with creating outputs from each asset because each project has different risks associated with developing and marketing the compound to customers. The projects are intended to treat significantly different medical conditions, and each project has a significantly different potential customer base and expected market and regulatory risks associated with the assets. Thus, Pharma Co. concludes that substantially all of the fair value of the gross assets acquired is not concentrated in a single identifiable asset or group of similar identifiable assets and that it must further evaluate whether the set has the minimum requirements to be considered a business. Copyright 2017 Deloitte Development LLC. All rights reserved. 17

18 Clarifying the Definition of a Business Substantive Process No Outputs When a set does not have outputs (for example, an early stage company that has not generated revenues) the set would have both an input and a substantive process that together significantly contribute to the ability to create outputs if it includes: An organized workforce that has the necessary skills, knowledge, or experience necessary to perform an acquired process (or group of processes) that when applied to another acquired input(s) is critical to the ability to develop or convert that acquired input into outputs. When no outputs are present, the set must have both a workforce and input that works together to contribute to the ability to create outputs. In the evaluation of whether an acquired workforce is performing a substantive process, the following factors should be considered: A process is not critical if considered minor or ancillary in the context of all the processes required to create outputs Inputs that an organized workforce could develop or convert into outputs include intellectual property, resources that could be developed to create outputs, access to necessary materials or rights that enable the creation of future outputs Copyright 2017 Deloitte Development LLC. All rights reserved. 18

19 Clarifying the Definition of a Business Substantive Process No Outputs Case C: Acquisition of Biotech Pharma Co. buys all of the outstanding shares of Biotech. Biotech s operations include research and development activities on several drug compounds that it is developing (inprocess research and development projects). The in-process research and development projects are in different phases of the U.S. Food and Drug Administration approval process and would treat significantly different diseases. The set includes senior management and scientists that have the necessary skills, knowledge, or experience to perform research and development activities. In addition, Biotech has long-lived tangible assets such as a corporate headquarters, a research lab, and lab equipment. Biotech does not yet have a marketable product and, therefore, has not generated revenues. Assume that each research and development project has a significant amount of fair value Because the set does not have outputs, Pharma Co. evaluates the criteria in paragraph D to determine whether the set has both an input and a substantive process that together significantly contribute to the ability to create outputs. Pharma Co. concludes that the criteria are met because the scientists make up an organized workforce that has the necessary skills, knowledge, or experience to perform processes that when applied to the in-process research and development inputs is critical to the ability to develop those inputs into a product that can be provided to a customer. Pharma Co. also determines that there is a more-thaninsignificant amount of goodwill (including the fair value associated with the workforce), which is another indicator that the workforce is performing a critical process. Thus, the set includes both inputs and substantive processes and is a business. Copyright 2017 Deloitte Development LLC. All rights reserved. 19

20 Clarifying the Definition of a Business Substantive Process Outputs If the set has outputs (i.e., there is a continuation of revenues before and after the transaction), the set would have both an input and a substantive process that together significantly contribute to the ability to create outputs when any of the following are present: Employees that form an organized workforce that has the necessary skills, knowledge, or experience to perform an acquired process that is critical to the ability to continue producing outputs. An acquired contract that provides access to an organized workforce that has the necessary skills, knowledge, or experience to perform an acquired process that is critical to the ability to continue producing outputs (considering the duration and renewal terms of the contract). The acquired process cannot be replaced without significant cost, effort or delay in the ability to continue producing outputs The acquired process is considered unique or scarce When outputs are present, a workforce is not required. The last three criteria address when a process is substantive without a workforce. Outputs are not determinative and customer contracts, customer lists or leases are excluded from being considered a substantive process. Copyright 2017 Deloitte Development LLC. All rights reserved. 20

21 Clarifying the Definition of a Business Substantive Process Outputs Case F: License of Distribution Rights Company A is a distributor of food and beverages. Company A enters into an agreement to sublicense the Latin American distribution rights of Yogurt Brand F to Company B, whereby Company B will distribute Yogurt Brand F in Latin America. As part of the agreement, Company A transfers the existing customer contracts in Latin America to Company B and an at-market supply contract with the producer of Yogurt Brand F. Company A retains all of its employees and distribution capabilities The set has outputs through the continuation of revenues with customers in Latin America. As such, Company B must evaluate the criteria in paragraph E to determine whether the set includes an input and a substantive process that together significantly contribute to the ability to create outputs. Company B considers whether the acquired contracts are providing access to an organized workforce that performs a substantive process. However, because the contracts are not providing a service that applies a process to another acquired input, Company B concludes that the substance of the contracts are only that of acquiring inputs. The set is not a business because: a. It does not include an organized workforce that could meet the criteria in paragraph E(a) through (b). b. There are no acquired processes that could meet the criteria in paragraph E(c) through (d). c. It does not include both an input and a substantive process. Copyright 2017 Deloitte Development LLC. All rights reserved. 21

22 Clarifying the Definition of a Business Impact of ASU ? Ixempra Diabetes Erbitux Japan Mexico and Brazil OTC Products Erbitux America Virology Discovery Copyright 2017 Deloitte Development LLC. All rights reserved. 22