ADVANCED ACCOUNTING COURSE

Exercises Program – Case n°2C

CHILPILLS, AN INTERNATIONAL SPECIALTY PHARMA COMPANY

Advanced accounting course

Exercises Program – Case n°2C
Background

Chillpills, a Belgian-based international specialty pharma company (closing date on 31 December), announced
in year Y it has completed the acquisition of Miracurall, a pharmaceutical company with activities in research,
development, manufacturing, and marketing of novel medicines in the therapeutic field of central nervous
disorders. This acquisition is part of Chillpills' strategy to focus solely on "biopharmaceuticals" - a combination
of large, antibody-based molecules and small, chemically-derived molecules. Miracurall’s products are mostly
prescription-only medications and are mainly distributed by pharmaceutical wholesalers. Miracurall is
operating in similar geographical areas as Chillpills.

The total purchase consideration amounting to EUR 300 million paid cash includes on the one hand the
production and research facilities (EUR 150 million), receivables (EUR 50 million). On the other hand,
Miracurall has a major new breakthrough molecule in advanced phase III clinical trials for indication of
rheumatoid arthritis. The fair value of this compound in development has been estimated at EUR 100 million
in the context of the acquisition.

After additional R&D expenses for final tests amounting to EUR 5 million in Y+1, Chillpills received regulatory
and marketing approval to sell the product on 13 February Y+2 for a patent period expiring on 13 February
Year +22. Last improvements to the design of the packaging required an additional spending of EUR 0,8
million mid-March Y+2 and Chillpills finally started the production process on 1 April Y+2. To boost the
launch of the product, further sales and marketing expenditure such as training the sales force and performing
market research have been incurred over the 9 remaining months of Y+2 for a total of EUR 0,5 million.

In January of Y+3, Chillpills and Medscape entered into a license and development agreement. Medscape is a
biopharmaceutical company dedicated to discovering new treatments for Parkinson’s disease. Chillpills and
Medscape wish to collaborate in the development of compounds based on the Medscape IP targeting the
Parkinson’s disease. Each party will undertake the necessary research and development activities designed to
select and develop a new product through to completion of the clinical trial. Further to the successful
completion of the trial, Chillpills will have the sole right and responsibility for the exploitation of the product
at its own cost. Medscape grants Chillpills an exclusive license under the Medscape IP to research, develop
and commercialize the product.

In consideration of the rights granted to Chillpills by Medscape, Chillpills will make various payments to
Medscape including the following:

1. Chillpills pays a one-time, non-refundable upfront fee in the amount of EUR 7 million at signing date;
2. Medscape is entitled to potential development, regulatory and sales-based milestones payments of up to
EUR 8,5 million at the following dates:
a. Commencement of the GLP Toxicology in-life phase (EUR 3 million)
b. First Clinical Study subject in the First Efficacy Clinical Trial dosed with the product (EUR 2,5
million)
c. First Marketing Authorization for sale in the US of the product (EUR 1 million)
3. Medscape will be entitled to royalties on net sales.

Through the press release dated 14 May Y+3, Chillpills announced the achievement of the first milestone.

Finally, in Y+4, Chillpills started developing a new migraine drug. Based on the entity’s system, cost of
research and development can be determined reliably. Development of the drug was well advanced and
management expected the drug to contribute substantial revenues in the following year. There were a number
of clinical trials outstanding and the likelihood of success was not known. The costs incurred included market
researches (EUR 6 million), depreciation expenses linked to the research facilities (EUR 9 million) and
salaries of the engineers on the project (EUR 1 million).

Advanced accounting course

Exercises Program – Case n°2C
Questions

1) Should Chillpills recognise the promising new molecule on its balance sheet? Please justify your response.
If so, when should it capitalise it and when should it begin amortising it? Please suggest the journal
entries in the accounting books of Chillpills for year Y.

2) How should the costs incurred in Y+1 an Y+2 be accounted for? Please justify your response and propose
the journal entries in the accounting books of Chillpills for the years Y+1 and Y+2.

3) How should the upfront fee and subsequent milestones payments be accounted for in the accounting
records of Chillpills? Please record the journal entries in the accounting books of Chillpills for the year
Y+3.

4) Should Chillpills capitalise in Y+4 part of the development costs linked to its new migraine drug as an
intangible asset? Why? Please present the journal entries in the accounting books of Chillpills for the year
Y+4 on this basis.

Advanced accounting course

Exercises Program – Case n°2C
Suggested solution

1) Following IAS 38 § 21, an intangible asset is recognized (a) if it is probable that the expected future
economic benefits that are attributable to the asset will flow to the entity and (b) if the cost of the asset
can be measured reliably. The probability criterion (a) is always considered to be satisfied for separately
acquired intangible assets. The price that is paid to acquire an intangible asset reflects expectations about
the probability that the expected future economic benefits embodied in the asset will flow to the entity.
The effect of probability is reflected in the cost of the asset and the probability recognition criterion in
IAS 38 § 21 is therefore always considered to be satisfied for separately acquired intangible assets (IAS
38 § 25). As it meets the definition of an intangible asset, Chillpills will recognize an intangible asset in
year Y.

Amortisation of an asset starts when it becomes available for use. The asset should be in the location and
condition that is required for it to be operating in the manner intended by management (IAS 38 § 97).
Amortization should begin from the date the asset is available for use. Prior to that date, the intangible
asset should be tested for impairment at least annually, irrespective of whether any indication of
impairment exists (IAS 36 § 10 (a)). Therefore, Chillpills will start amortising the intangible asset as from
13 February Y+2 over the patent life of 20 years.

The journal entries are as follows:

Year Y

DT Property, Plant & Equipment 150,000,000

DT Intangible assets 100,000,000

DT Receivables 50,000,000

CR Cash and cash equivalents 300,000,000

2) Development costs are capitalised as an intangible asset if all of the following criteria are met [IAS 38.57]:

a. the technical feasibility of completing the asset so that it will be available for use or sale;
b. the intention to complete the asset and use or sell it;
c. the ability to use or sell the asset;
d. the asset will generate probable future economic benefits and demonstrate the existence of a market
or the usefulness of the asset if it is to be used internally;
e. the availability of adequate technical, financial and other resources to complete the development and
to use or sell it;
f. the ability to measure reliably the expenditure attributable to the intangible asset.

Chillpills should expense sales and marketing expenditure such as training a sales force or performing
market research. This type of expenditure does not create, produce or prepare the asset for its intended
use. Expenditure on training staff, selling and administration should not be capitalised [IAS 38.67].
However, costs incurred to improve the design of the packaging should be capitalised as from March Y+2.

The journal entries are as follows:

Year Y+1

DT R&D expenses 5,000,000

CR Cash and cash equivalents 5,000,000

No amortisation expense will be accounted for in year Y+1 before the market authorisation.

Advanced accounting course

Exercises Program – Case n°2C
 Year Y+2

DT R&D expenses 500,000

CR Cash and cash equivalents 500,000

DT Intangible assets 800,000

CR Cash and cash equivalents 800,000

DT Amortisation expense 4,439,944

CR Intangible assets – Accumulated amortisation 4,439,944

Start date Y+2 13-Feb 15-Mar

Closing date Y+2 31-Dec 31-Dec
# Days 322 291
End of useful life (in Y+22) 13-Feb 13-Feb
# Days 7305 7274

GBV 100.000.000 800.000

Y+2 amortization 4.407.940 32.004

3) Although these licenses are obtained when the program is still in the research phase, the capitalization is
not impacted by the restrictions in IAS 38 related to the “research phase” in paragraphs 54-56 as that
section is only referring to internally generated intangibles. The upfront fee (and the subsequent
milestones) is for the acquisition of a license which meets the definition of an intangible, regardless of
the fact it is in the research or development phase. As the license meets the definition of an intangible
asset, Chillpills will recognize an intangible asset and amortize the amount paid over the related
commercial life starting with regulatory approval of the first product.

Chillpills will pay research, development and sales milestones based on various milestone events tied
with the research, development and commercialization of the product. As the royalties are considered
to be fair market value rates, these amounts will be capitalized as intangible assets as they are
considered additional consideration for the license if they can be measured reliably.
Under IAS 38.21 and 38.25, these payments can be capitalized as intangible assets regardless of the fact
that the compound has not received regulatory approval. For acquired intangible assets it is always
assumed that the asset meets the probability criteria for asset recognition.

Consequently, the suggested journal entries are as follows:

January Y+3

DT Intangible assets 7,000,000

CR Cash & cash equivalents 7,000,000

May Y+3

DT Intangible assets 3,000,000

CR Cash & cash equivalents 3,000,000

Advanced accounting course

Exercises Program – Case n°2C
 December Y+3

No amortisation expense will be accounted for on the upfront payment and the first milestone in year
Y+1 before the market authorisation. However, the amortisation on the previously acquired
breakthrough asset should be accounted for.

DT Amortisation expense 5,036,721

CR Intangible assets 5,036,721

Start date Y+2 13-Feb 15-Mar

Closing date Y+3 31-Dec 31-Dec
# Days 365 365
End of useful life (in Y+22) 13-Feb 13-Feb
# Days 7305 7274

GBV 100.000.000 800.000

Y+3 amortization 4.996.578 40.143

4) Development costs are capitalized as an intangible asset if all criteria in IAS 38 § 57 are met. The starting
point for capitalization of internal development costs is based on the facts and circumstances of each
project. However a strong indication that all criteria of IAS 38 § 57 are met, arises when Chillpills would
file its submission to the regulatory authority for final approval as it is the clearest point at which technical
feasibility of completing the asset is proven which is the most difficult criterion to demonstrate (IAS 38
§ 57 (a)). As the development costs made by Chillpills in this case will mainly arise before submission to
the regulatory authority and that the probability of success is unknown, the development costs will be
expensed in P&L as incurred.

Consequently, the journal entries are as follows:

Year Y+4

DT R&D Costs 16,000,000

CR Cash and cash equivalents 7,000,000

CR P.P. & E. – Accumulated depreciation 9,000,000

And the yearly amortisation of the previously acquired molecule

DT Amortisation expense 5,036,721

CR Intangible assets 5,036,721

Advanced accounting course

Exercises Program – Case n°2C