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IND-AS: Impact On Pharma Industry

Published on Fri, Jul 17,2015 | 22:54, Updated at Fri, Jul 17 at 22:54Source : 

By: Santosh Maller & Navneet Mehta, EY

The application of Ind-AS is expected to have a significant impact on the Indian pharmaceuticals industry. There are significant differences between the Indian GAAP and Ind-AS, which are expected to impact companies in this industry. This article highlights certain peculiar differences, which may arise on transition of Indian companies in this sector.

Product Sales
There is a significant diversity of accounting treatment under Indian GAAP on revenue recognition than Ind-AS.  Under Indian GAAP, the accounting practices are more driven from the legal form given in the agreement, rather than their true economic substance but the application of Ind-AS 115 Revenue from Contract with Customers may change the revenue recognition policies and practices followed.

Under Indian GAAP, the timing of revenue recognition from the sale of goods is primarily based on the transfer of risks and rewards. Ind-AS115 instead focuses on when control of those goods has transferred to the customer. This change in model may result in a change of timing for revenue recognition for some entities.

In the global arena, there are certain practices such as channel dumping and the sale of short-dated inventory, which have recently been put under more rigorous scrutiny.

(i)    In a channel stuffing /dumping arrangement, a company inflates its revenue figures by forcing more products through is pre-existing distribution channel than that distribution channel is capable of selling. This may be done by inducing distributors to accept additional products a few days prior to period ends, often with more favourable payment or return conditions, to meet their performance targets. For example, a company may sell products to the distributor with an additional right of return, agree to payment terms whereby the distributor will pay only on the actual realization or receive additional discounts based on the inventory holding period.

(ii)         Companies typically have a policy to sell products with a minimum amount of remaining shelf life at the reporting date. However, in a sale of “short dated” inventory, it may enter in an arrangement with the distributor, whereby it will be given an additional benefit for selling such inventory. Further, since the distributor typically has a right to return expired goods, the risk of return may be higher in these cases.

The application of Ind-AS 115 will require Indian companies to carefully evaluate accounting for such arrangements.  Under Ind-AS 115, revenue should not be recognized for goods expected to be returned, and a liability should be recognized for expected refunds to customers. The refund liability should be updated each reporting period for changes in expected refunds.

An asset and corresponding adjustment to cost of sales should be recognized for the right to recover goods from customers on settling the refund liability. The asset will be initially measured at the cost of inventory sold less any expected costs to recover the goods and the impact of any reduction in the value of those goods. This asset needs to be tested for impairment. At the end of each reporting period, the asset should be re-measured (if necessary) based on changes in expectations. The impact of returns be estimated using a probability-weighted approach or most likely outcome, whichever is most predictive. Consideration received is included in revenue to the extent that it is probable (highly probable) that there will be no significant reversal when the uncertainty is resolved. Exchanges of products for another of the same type, quality, condition and price are not considered returns.

Under Ind-AS, an entity needs to determine the transaction price, which is the amount of consideration it expects to be entitled to in exchange for transferring promised goods or services to a customer. The transaction price might include an element of consideration that is variable or contingent on the outcome of future events, including (but not limited to) discounts, rebates, price concessions, refunds, returns, credits, incentives, performance bonuses, and royalties. Consideration payable by an entity to a customer is accounted for as a reduction of the transaction price unless the payment is for a distinct good or service that the customer transfers to the entity.

Strategic Alliance Transactions/Collaborative Arrangements
Pharmaceutical and biotechnology companies often enter strategic alliance transactions/collaborative arrangements. These arrangements can take various forms and often include unique structures and terms. In many cases, these transactions include an upfront payment for the license of technology, ongoing reimbursements for research and development (R&D) services, additional payment on the achievement of specific milestones and ongoing royalties. Arrangements may also provide the licensee with the right to manufacture or co-promote the licensed product. From a substance perspective, these arrangements may have multiple distinct performance obligations.

The current Indian GAAP does not contain any specific requirement for the application of the revenue recognition criteria to each element. Thus, it is likely that companies may be following differing practices on this matter. Ind-AS 115 requires the revenue recognition criteria to be applied to each separately identifiable performance obligation of the transaction so as to reflect its economic substance.

Ind-AS 115 requires entities to assess whether the counterparty to the arrangement is (1) a customer or (2) a collaborator or partner sharing in the risks and benefits of the arrangement. If such arrangements are outside the scope of Ind-AS 115, the related income might not meet the definition of revenue, but instead be recorded as a reduction of R&D expense or as other income.

In arrangements where licenses are granted by the licensor provides the licensee with the right to use, but not own, the licensor’s intellectual property.  For example, many pharmaceutical companies out-license their IPs developed related to a drug that has not yet received regulatory approval. The licensees may have rights to further develop the IP, and commercially manufacture and/or sell the resulting product. The licensor typically receives an upfront fee, milestone payments for specific clinical outcomes, and sales-based royalties as consideration for the license. In some cases, the licensor may have ongoing involvement, such as, to provide R&D or manufacturing services.

Determining whether a license is distinct from other goods and services in an arrangement is a key part of applying the model under Ind-AS. Licenses together with other services, such as R&D, must first be assessed to determine if the license is distinct. If the license is not distinct, then the license is combined with other goods or services into a single performance obligation. Revenue is recognized as the licensor satisfies the combined performance obligation. Distinct licenses are required to be classified into rights to use IP, recognized at a point in time, or access rights, recognized over period of time.

Research & Development
R&D activities are critical to the success of this industry. Companies in this sector invest a significant amount of capital to find new drug candidates in the anticipation of generating future revenues. Indian companies are largely in the generics market as it is considered comparatively less capital extensive than the market for the development of a new molecule. However, this does not mean that they are not incurring any significant cost on R&D activities. Even in the generics space, costs incurred in developing the test batch, carrying out bio-equivalence tests and filing fees are significant. Companies also incur expenditure on acquiring in-process R&D projects, e.g., in a business combination.

With regard to the treatment of internal R&D costs, there is no significant difference between Indian GAAP and Ind-AS. However, once Indian entities start applying Ind-AS, their accounting practices will be benchmarked to global peers, and thereby make them subject to a higher level of scrutiny, both nationally and globally. To meet higher expectations, Indian companies will need to formulate a robust policy on the recognition of R&D costs as an intangible asset. On the lines of the current Indian GAAP, Ind-AS 38 Intangible Assets also does not provide any specific guidance on this issue. However, it is observed that global companies typically start capitalizing development costs only when regulatory approval is obtained and the amount capitalized compared to the total spend may be negligible.

With regard to in-process R&D acquired as a part of business combination, current Indian GAAP generally require/allow book value measurement which means that most Indian acquirers may not have recognized the same as a separate asset. Under the Ind-AS, an in-process research and development project of the acquiree to be recognized separately if it meets the definition of an intangible asset. This will not only impact the determination of goodwill, but will also have future amortization and impairment implications.

Contract Manufacturing
Many pharmaceuticals companies use structures such as special purpose entities (SPE) or outsourcing/sub-contracting arrangements to fund a part of their R&D costs, share risks or bring more efficiency. These may take the form of sale, purchase or service contracts and are treated as such under the Indian GAAP. In the Ind-AS regime, accounting for such arrangements will be governed by their economic substance. Companies will particularly need to consider the following aspects:

(i)           Whether a company in substance controls the SPE: Ind-AS 110 Consolidated Financial Statements delineates specific guidance to facilitate the application of the concept of control in such cases, which, among other factors, requires the consideration of a decision-making power, purpose and design of the SPE, risks that the SPE is exposed to and rights to the returns. If a company determines that it, in substance, controls the SPE, it will need to consolidate the same, which may have various other business implications.

(ii)         Embedded leases: If the arrangements with contract manufacturers are assessed as in substance leases under Ind-AS, the lease will be accounted for either as operating or finance leases. Such accounting may have significant implications on the financial statements of both the entities. Finance lease accounting will require the service provider to derecognize the underlying asset(s) from its financial statements and the same will get recognized in the financial statements of the customer. If a lease is evaluated to be an operating lease, the straight-lining of leases may have a significant impact.

Free Samples
Pharmaceutical companies distribute a significant part of their products as “free samples” to physicians and hospitals so as to increase awareness about their product. The cost of these samples is recognized as a marketing expense under both the Indian GAAP and Ind-AS. However, the key issue is regarding the timing of expense recognition.

AS 26 under Indian GAAP requires advertising/marketing expenditure to be expensed off as and when incurred, without providing any guidance on the notion “when it is incurred.” The ICAI’s Expert Advisory Committee has issued an opinion, which requires the stock of samples to be disclosed under the head “current assets.” These are written off to profit and loss when actually distributed.

The notion of “… when it is incurred” has been dealt with more clearly in Ind-AS. Ind-AS 38 clarifies that the advertising and promotional expenditures are recognized as an expense when the entity has the right to access the goods or when it receives the services. Therefore, this may require companies to recognize product costs as a marketing expense when it is packaged as sample product and not when it is distributed free.

In addition, when converting to Ind-AS, Indian pharmaceutical companies will need to deal with many other accounting differences such as those related to property, plant and equipment, business combinations, financial instruments, joint ventures, financial liabilities and equity, amortization of intangible assets, employee compensation, stock options, among others.

The conversion to Ind-AS exercise is not an accounting exercise only. Rather, it is an exercise in change management, which may impact various other aspects of business such as performance management, IT systems and tax compliance. Further, as companies prepare themselves for Ind-AS, it is also required that they keep investors, analysts and other stakeholders informed about the potential impact so that there are no last-minute surprises. The date of conversion to Ind-AS is not very far. Keeping this in view, it is high time that Indian pharmaceutical companies immediately prepare themselves for Ind-AS. This will help them address all issues effectively.


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