Question

NN Pharma, a pharmaceutical company in Iceland, owns and maintains a portfolio of patents related to an antibiotic that treats life-threatening diseases. On February 23, 20X8, NN grants BTX (a pharmaceutical company in Saudi Arabia) the exclusive right to use its patented drug formula to commercialize and supply the antibiotic in the MENA Region. The intellectual property (IP) is fully developed, and regulatory approval has been obtained; therefore, BTX is able to commercialize the IP. NN has determined that the patented drug formula is functional IP and that therefore, the license grants BTX the right to use the IP.

In exchange for the exclusive right to use the patented drug formula, BTX agrees to pay NN Pharm the following amounts:

1. An up-front fee of $300 million.

2. Annual fixed fees of $50 million payable at the end of each year in which

the contract is effective.

3. Sales-based royalties of 5 percent of BTX’s sales of the antibiotic in Saudi Arabia (recognized in accordance with the sales-based royalty exception in ASC 606-10-55-65).

The contract states that BTX has the exclusive right to use the patented drug formula through the patent term, which expires in 10 years (i.e., the contract ends when the patent expires). The contract also states that BTX may terminate

the contract before the expiration of the patent by providing three months’ notice to NN Pharma. All amounts already paid by BTX are nonrefundable in the event of early termination. The contract does not include an explicit termination penalty (i.e., BTX is not required to pay additional cash consideration to NN Pharma upon early termination); however, upon early termination, the right to the patented drug formula in MENA would revert back to NN Pharma, which would be able to relicense the patented drug formula to a different pharmaceutical company in the MENA region. This alternative is only available to BTX and only if BTX terminates the contract before the end of the 10-year term.

Questions: (1) what is the contract period here? (2) how should BTX account for the upfront payment (it’s a cost to BTX)? (3) how should NN Pharma account for the upfront payment (its revenue to NN)? (4) How should NN account for the royalty payments (revenue)? And (5) how should NN account for the fixed annual payments (revenue)?

Answer 1

1. Company is required to assess whether a contract is cancellable when determining contract period and, if so, whether there is a substantive termination penalty in the event that the contract is cancelled. It is important to note 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.

In the given case, contract has specified a term of 10 years. Even though parties can terminate it before its expiry, neither of the parties has the intention to do so at the inception of the contract. Also, if the contract is to be terminated by BTX, no amounts already paid will be refunded. Therefore, contract term is 10 years.

2. Upfront Payment of $300 million made by BTX to NN Pharma is Non-refundable. Also, this one-time payment doest not allow usage of Intellectual Property by BTX. Usage of such IP depends on payment of annual fixed fee of $50 million. If BTX pays annual fixed fee for any year, it can use IP rights for that particular year. So no performance obligation is met when this upfront fee is paid. Therefore, such payment made should be treated as deferred expense which should be recognised as expense during the contract period of 10 years by BTX.

3. As per IFRS 15, Upfront fee received by NN Pharma should be treated as deferred revenue as there is no separate performace obligation related to such receipt is met immediately but throughtout the contract period.

4. For a licence of intellectual property for which the consideration is based on the customer’s subsequent sales or usage, an entity does not recognise any revenue for the variable amounts until the uncertainty is resolved (i.e., when a customer’s subsequent sales or usage occurs).

In the given case, BTX also agrees to pay Sales-based royalties of 5 percent of BTX’s sales of the antibiotic in Saudi Arabia. This amount of royalty remains uncertain till the actual sales of the antibiotic is confirmed by BTX. Therefore, NN Pharma shall not recognise such royalty as revenue till the uncertainity is resolved i.e., BTX's subsequent sales are confirmed.

5. Annual Fixed Fee of $50 million pertains to usage of each year separately. Therefore performance obligation relating to such payment is met during the same year. So, such Annual fixed fee of $50 million shall be recognised as Revenue in the same year.