Critical accounting policies and estimates
Our Financial Statements are prepared in accordance with International Financial Reporting Standards (IFRS) as adopted by the European Union (adopted IFRS) and as issued by the International Accounting Standards Board and the accounting policies employed are set out under the heading ‘Financial Statements – Accounting Policies’. In applying these policies, we make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities. The actual outcome could differ from those estimates. Some of these policies require a high level of judgement, either because the areas are especially subjective or complex. We believe that the most critical accounting policies and significant areas of judgement and estimation are in revenue recognition, research and development, goodwill and intangible assets, provisions for contingent liabilities, post-retirement benefits, taxation and share-based compensation.
Revenue recognition
Revenue represents sales of products to external third parties and excludes inter-company income and value added taxes. We also receive income from royalties and from disposals of intellectual property, brands and product lines which are included in other operating income.
Sales of products to third parties: Sales revenue is recorded at the invoiced amount (excluding sales and value added taxes) less estimated accruals for product returns and rebates given to managed care and other customers – a particular feature in the US. Cash discounts for prompt payment are also deducted from sales. Revenue is recognised at the point of delivery, which is usually when title passes to the customer either on shipment or on receipt of goods by the customer depending on local trading terms.
At the time of invoicing sales in the US, rebates and deductions that we expect to pay, generally over the following six to nine months, are estimated. These rebates typically arise from sales contracts with third party managed care organisations, hospitals, long-term care facilities, group purchasing organisations and various state programmes (Medicaid ‘best price’ contracts, supplemental rebates etc) and can be classified as follows:
- Chargebacks, where we enter into arrangements under which certain parties, typically hospitals, the Department of Veterans Affairs and the Department of Defense, are able to buy products from wholesalers at the lower prices we have contracted with them. The chargeback is the difference between the price we invoice to the wholesaler and the contracted price charged by the wholesaler. Chargebacks are paid directly to the wholesalers.
- Regulatory, including Medicaid and other federal and state programmes, where we pay rebates based on the specific terms of agreements in individual states which include product usage and information on best prices and average market prices.
- Contractual, under which entities such as third party managed care organisations, long-term care facilities and group purchasing organisations are entitled to rebates depending on specified performance provisions, which vary from contract to contract.
Accrual assumptions are built up on a product-by-product and customer-by-customer basis taking into account specific contract provisions coupled with expected performance and are then aggregated into a weighted average rebate accrual rate for each of our products. Accrual rates are reviewed and adjusted on a monthly basis. There may be further adjustments when actual rebates are paid after the initial sale based on utilisation information submitted to us (in the case of contractual rebates) and claims/invoices (in the case of regulatory rebates and chargebacks). We believe that we have been reasonable in our estimates for future rebates using a similar methodology to that of previous years. Inevitably, however, such estimates involve judgements on aggregate future sales levels, segment mix and the respective customer contractual performance.
Cash discounts are offered to customers to encourage prompt payment. Accruals are calculated based on historical experience and are adjusted to reflect actual experience.
Industry practice in the US allows wholesalers and pharmacies to return unused stocks within six months of, and up to 12 months after, shelf-life expiry. At point of sale, we estimate the quantity and value of goods which may ultimately be returned. Our returns accruals are based on actual experience over the preceding 12 months for established products together with market related information such as estimated stock levels at wholesalers and competitor activity. For newly launched products, we use rates based on our experience with similar products or a pre-determined percentage. For products facing generic competition (such as Toprol-XL in the US) our experience is that we usually lose the ability to estimate the levels of returns from wholesalers with the same degree of precision that we can for products still subject to patent protection. This is because we have limited or no insight into a number of areas – the actual timing of the launch of a generic competitor following regulatory approval of the generic product (for example, a generic manufacturer may or may not have produced adequate pre-launch inventory), the pricing and marketing strategy of the competitor, the take-up of the generic and (in cases where a generic manufacturer has approval to launch just one dose size in a market of several dose sizes) the likely level of switching from one dose to another. Under our accounting policy revenue is only recognised when the amount of the revenue can be measured reliably. Our approach in meeting this condition for products facing generic competition will vary from product to product depending on the specific circumstances; in the case of Toprol‑XL (the only product affected in the years under review), which faced competition from several generic manufacturers from the time of launch of the first generic in 2006, we believed that revenue from all doses in the US could only be measured reliably on writing of the ultimate prescription (at which point the right of return is extinguished). Accordingly, the point of delivery is the point at which the prescription has been written. Overall, we believe that our estimates are reasonable.
The effects of these deductions on our US pharmaceuticals turnover, and the movements on accruals, are set out in the tables below.
The adjustments in respect of prior years benefited reported US pharmaceuticals turnover by 1.9% and 0.4% in 2005 and 2006 respectively and decreased turnover by 0.4% in 2007. However, taking account of the following year’s reversal the net impact on 2006 and 2007 was a 1.3% and a 0.8% overstatement of US pharmaceuticals turnover, respectively.
The increase in contractual rebates in 2007 was driven by the introduction into the US market of generic omeprazole, with resultant price impacts on Nexium.
Regulatory rebates decreased by $341 million in 2006 compared to 2005, as a result of the automatic switch of those patients in state Medicaid programmes into Medicare Part D, classified as a contractual rebate. Contractual rebates increased by $1,212 million compared to 2005, partly as a result of this switch, and also due to volume growth.
A further factor that significantly influenced our sales in the US market prior to 2004 was wholesaler buying patterns. Wholesalers could place orders that were significantly larger than their normal levels of demand ahead of anticipated price increases or would seek to build up or run down their stock levels for other reasons. Such speculative purchases made forecasting sales patterns more difficult and could drive variances between reported and underlying demand at quarter end. In December 2003 we entered into Inventory Management Agreements to reduce the opportunity for such speculative purchases. In 2005 we replaced the Inventory Management Agreements with Distribution Service Agreements, which served to reduce even further the speculative purchasing behaviour of the wholesalers. As a result, we believe inventory movements have been neutral across the year. We continue to track wholesaler stock levels by product, using our own, third party and wholesaler data and, where we believe such distortions occur, we disclose in the Annual Report for each product and in aggregate where shipments may be out of line with underlying prescription trends. We do not offer any incentives to encourage wholesaler speculative buying and attempt, where possible, to restrict shipments to underlying demand when such speculation occurs.
- Royalty income: Royalty income is recorded under other operating income in the Financial Statements. Royalties tend to be linked to levels of sales or production by a third party. At the time of preparing the Financial Statements, we may have to estimate the third party’s sales or production when arriving at the royalty income to be included. These estimates, which may differ from actual sales or production, do not result in a material impact on reported other operating income.
- Sales of intangible assets (such as intellectual property, brands and product lines): A consequence of charging all internal R&D expenditure to the income statement in the year that it is incurred (which is normal practice in the pharmaceutical industry) is that we own valuable intangible assets which are not recorded on the balance sheet. We also own acquired intangible assets which are included on the balance sheet. As a consequence of regular reviews of product strategy, from time to time we sell such assets and generate income. Sales of product lines are often accompanied by an agreement on our part to continue manufacturing the relevant product for a reasonable period (often about two years) whilst the purchaser constructs its own manufacturing facilities. The contracts typically involve the receipt of an upfront payment, which the contract attributes to the sale of the intangible assets, and ongoing receipts, which the contract attributes to the sale of the product we manufacture. In cases where the transaction has two or more components, we account for the delivered item (for example, the transfer of title to the intangible asset) as a separate unit of accounting and record revenue on delivery of that component provided that we can make a reasonable estimate of the fair value of the undelivered component. Where the fair market value of the undelivered component (for example, a manufacturing agreement) exceeds the contracted price for that component we defer an appropriate element of the upfront consideration and amortise this over the performance period. However, where the fair market value of the undelivered component is equal to or lower than the contracted price for that component we treat the whole of the upfront amount as being attributable to the delivered intangible assets and recognise that part of the revenue upon delivery. No element of the contracted revenue related to the undelivered component is allocated to the sale of the intangible asset. This is because the contracted revenue relating to the undelivered component is contingent on future events (such as sales) and so cannot be anticipated.
| 2007 $m |
2006 $m |
2005 $m |
|
|---|---|---|---|
| Gross sales | 18,456 | 16,577 | 14,013 |
| Chargebacks | (1,130) | (975) | (905) |
| Regulatory – US government and state programmes | (732) | (532) | (873) |
| Contractual – Managed care and group purchasing organisation rebates | (3,179) | (2,413) | (1,201) |
| Cash and other discounts | (356) | (329) | (405) |
| Customer returns | (18) | (46) | 14 |
| Other | (145) | (256) | (244) |
| Net sales | 12,896 | 12,026 | 10,399 |
| Brought forward 1 January 2005 $m |
Provision for current year $m |
Adjustment in respect of prior years $m |
Returns and payments $m |
Carried forward at 31 December 2005 $m |
|
|---|---|---|---|---|---|
| Chargebacks | 118 | 927 | (22) | (838) | 185 |
| Regulatory – US government and state programmes | 493 | 970 | (97) | (765) | 601 |
| Contractual – Managed care and group purchasing organisation rebates | 490 | 1,284 | (83) | (1,271) | 420 |
| Cash and other discounts | 23 | 405 | - | (401) | 27 |
| Customer returns | 282 | (14) | - | (101) | 167 |
| Other | 80 | 244 | - | (270) | 54 |
| 1,486 | 3,816 | (202) | (3,646) | 1,454 |
| Brought forward 1 January 2006 $m |
Provision for current year $m |
Adjustment in respect of prior years $m |
Returns and payments $m |
Carried forward at 31 December 2006 $m |
|
|---|---|---|---|---|---|
| Chargebacks | 185 | 1,001 | (26) | (1,068) | 92 |
| Regulatory – US government and state programmes | 601 | 597 | (65) | (819) | 314 |
| Contractual – Managed care and group purchasing organisation rebates | 420 | 2,367 | 46 | (2,198) | 635 |
| Cash and other discounts | 27 | 329 | - | (327) | 29 |
| Customer returns | 167 | 46 | - | (53) | 160 |
| Other | 54 | 256 | - | (263) | 47 |
| 1,454 | 4,596 | (45) | (4,728) | 1,277 |
| Brought forward 1 January 2007 $m |
Addition in respect of MedImmune $m |
Provision for current year $m |
Adjustment in respect of prior years $m |
Returns and payments $m |
Carried forward at 31 December 2007 $m |
|
|---|---|---|---|---|---|---|
| Chargebacks | 92 | 2 | 1,115 | 15 | (1,038) | 186 |
| Regulatory – US government and state programmes | 314 | 69 | 769 | (37) | (687) | 428 |
| Contractual – Managed care and group purchasing organisation rebates | 635 | 5 | 3,100 | 79 | (2,919) | 900 |
| Cash and other discounts | 29 | 1 | 356 | - | (348) | 38 |
| Customer returns | 160 | 1 | 19 | (1) | (94) | 85 |
| Other | 47 | - | 153 | - | (147) | 53 |
| 1,277 | 78 | 5,512 | 56 | (5,233) | 1,690 |
Research and development
Our business is underpinned by our marketed products and development portfolio. The R&D expenditure on internal activities to generate these products is generally charged to the income statement in the year that it is incurred. Purchases of intellectual property and product rights to supplement our R&D portfolio are capitalised as intangible assets. Such intangible assets are amortised from the launch of the underlying products and are tested for impairment both before and after launch. This policy is in line with practice adopted by major pharmaceutical companies.
Goodwill and intangible assets
We have significant investments in goodwill and intangible assets as a result of acquisitions of businesses and purchases of such assets as product development and marketing rights. Under adopted IFRS, goodwill is held at cost and tested annually for impairment, whilst intangibles are amortised over their estimated useful lives. Changes in these lives would result in different effects on the income statement. We estimate that a one year reduction in the estimated useful lives of intangible assets would increase the annual amortisation charge by $54 million. The majority of our investments in intangible assets and goodwill arose from the restructuring of the Astra-Merck joint venture in 1998 and the acquisition of MedImmune in 2007, and we are satisfied that the carrying values are fully justified by estimated future earnings. Intangible assets are reviewed for impairment where there are indications that their carrying values may not be recoverable, and any impairments are charged to the income statement. Tests for impairment are based on discounted cash flow projections, which require us to estimate both future cash flows and an appropriate discount rate. Such estimates are inherently subjective. Impairments to intangible assets totalling $120 million were recognised in 2007 (2006 $17 million, 2005 nil).
Contingent liabilities and commitments
In the normal course of business, contingent liabilities may arise from product-specific and general legal proceedings, from guarantees or from environmental liabilities connected with our current or former sites. Where we believe that potential liabilities have a low probability of crystallising or are very difficult to quantify reliably, we treat them as contingent liabilities. These are not provided for but are disclosed in the notes. Further details of these contingent liabilities are set out in Note 27 to the Financial Statements. Although there can be no assurance regarding the outcome of legal proceedings, we do not currently expect them to have a materially adverse effect on our financial position. We also have significant commitments that are not currently recognised in the balance sheet arising from our relationship with Merck. These are described more fully in ‘Off-balance sheet transactions, contingent liabilities and commitments’.
Post-employment benefits
We account for the pension costs relating to the retirement plans under IAS19 ‘Employee Benefits’. In applying IAS19, we have adopted the option of recognising actuarial gains and losses in full through reserves. In all cases, the pension costs are assessed in accordance with the advice of independent qualified actuaries but require the exercise of significant judgement in relation to assumptions for future salary and pension increases, long term price inflation and investment returns.
Taxation
Accruals for tax contingencies require management to make judgements and estimates in relation to tax audit issues and exposures. Amounts accrued are based on management’s interpretation of country-specific tax law and the likelihood of settlement. Tax benefits are not recognised unless the tax positions are probable of being sustained. Once considered to be probable, management reviews each material tax benefit to assess whether a provision should be taken against full recognition of the benefit on the basis of potential settlement through negotiation and/or litigation. All such provisions are included in creditors due within one year. Any recorded exposure to interest on tax liabilities is provided for in the tax charge.
Share-based compensation
Through the Remuneration Committee we offer share and share option plans to certain employees as part of their compensation and benefits packages, designed to improve alignment of the interests of employees with shareholders. Details of these are given in Note 26 to the Financial Statements. The charges have been calculated principally using the Black-Scholes model as a valuation basis.
