9. Pharmaceutical Sector

1. Baxalta business combination – valuation of acquired CMP intangible assets
Shire – Extract from Audit Report of Financial Statement 2016
Risk Description How the scope of our audit responded to the risk

The Directors’ determination of the purchase price allocation for the acquisition of Baxalta is included at Note 4 and the critical accounting policy and estimate in relation to acquired intangible assets is set out at Note 3.

We identified a risk that the allocation of the purchase price to currently marketed product (CMP) intangible assets acquired as part of the Baxalta business combination is not appropriate.

In particular there is risk that management has not determined appropriate assumptions for the impact that launches of competing products may have on future revenues from existing products.

We consider this to be a significant risk due to the size of the CMP intangible assets balance (preliminary valuation of $22.0 billion) in addition to the complexity and subjectivity of judgements.

In order to assess the valuation of the acquired CMP intangible assets, as part of the allocation of the purchase price, we have performed the following specific procedures:

  • independently assessed the design and implementation and tested operating effectiveness of the Group’s relevant financial controls;
  • assessed the competence and independence of management’s valuation expert, and used our own internal valuation experts to consider and challenge the appropriateness of valuation methodologies used and the accuracy of calculations; and
  • considered and challenged the Directors’ underlying judgements in light of existing internal evidence, market analyst expectations, publicly available competitor information and external market studies.
 
2. Valuation of acquired intangible assets affecting the acquisition accounting for Dyax 
Shire – Extract from Audit Report of Financial Statement 2016
Risk Description How the scope of our audit responded to the risk

The Directors’ determination of the purchase price allocation for the acquisition of Dyax is included at Note 4 and the critical accounting policy and estimate in relation to acquired intangible assets is set out at Note 3.

We identified a risk that the allocation of the purchase price to acquired assets and liabilities in relation to the Dyax business combination, in particular the valuation of the SHP-643 intangible asset, is not appropriate.  In particular there is risk that management has not determined appropriate assumptions for prevalence, efficacy, probability of clinical success (“POS”) and U.S. price rises.

This has been highlighted as a significant risk due to its size (SHP-643 has been valued at $4.1 billion) and the complexity and subjectivity of judgements.

In order to assess the valuation of the acquired Dyax intangible assets, as part of the allocation of the purchase price, we have performed the following specific procedures:

  • independently assessed the design and implementation and tested operating effectiveness of the Group’s relevant financial controls;
  • assessed the competence of management’s market expert and undertook a series of interviews with them to understand the scope and output of their work;
  • obtained the forecast models prepared by management’s market expert including the key assumptions for POS, price rises, prevalence rate and efficacy associated with the SHP-643 asset;
  • obtained evidence including external studies, market analyst reports and comparable product data and obtained an understanding of the primary information and opinions obtained from key opinion leaders by management’s market specialist, using this information to challenge the relevant assumptions made by management; and
  • assessed the competence and independence of management’s valuation expert, and used our own internal valuation experts to consider and challenge the appropriateness of valuation methodologies used and the accuracy of calculations.
3. The estimation of rebates against revenue as a result of contractual and regulatory requirements in the United States
Shire – Extract from Audit Report of Financial Statement 2016
Risk Description How the scope of our audit responded to the risk

A description of the key accounting policy for sales deductions is included at Note 2 and the critical accounting policy and estimate in relation to the level of rebates and other sales deductions is set out at Note 3.

The Directors are required to make certain judgements in respect of the level of rebates and other sales deductions that will be realised against the Group’s sales.

The largest of these judgements relate to rebates for Medicaid and Managed Care programmes, for which the Group held accrued rebates as at December 31, 2016 of $1,431 million (2015: $982 million) in aggregate. The risk is primarily focused on the Neuroscience and Gastro Intestinal products.

The key elements of the judgements relating to Medicaid and Managed Care rebates include:

  • the proportion of the inventory pipeline that will attract specific rebates; and
  • the future value of rebate per unit expected to be applicable.

We identified a risk that these judgements are not appropriate and, as a result, rebate liabilities and sales deductions are recorded at an incorrect level.

There is a significant track record of actual rebate levels which informs our assessment of the level of risk of material misstatement. Nevertheless due to the manual nature and extent of the accounting process in this area it forms a significant part of our audit effort and requires a notable level of resource within the audit engagement.

We have considered the Group’s processes for making judgements in this area and performed the following procedures:

  • considered the appropriateness of the process and tested the design, implementation and operating effectiveness of controls adopted by management in determining the accounting for rebates and other sales deductions;
  • undertook an analysis of the historical accuracy of judgements by reference to actual rebates paid in prior periods;
  • confirmed rebate levels accrued during the year against subsequent payments;
  • analysed and recalculated components of the year end liability based on contracted and statutory rebate rates; and
  • challenged the key elements of judgements that were made in the period in light of externally verifiable data, such as pipeline levels and industry practice.

We also evaluated the presentation and disclosure of the transactions within the Group financial statements.

4. Carrying value of goodwill following group reorganization
Novartis – Extract from Audit Report of Financial Statement 2016
Key audit matter How our audit addressed the key audit matter

The Group has goodwill of USD 31.0 billion at December 31, 2016.

In January 2016 the Group announced changes to the divisional structure with the former Pharmaceuticals Division becoming the Innovative Medicines Division and undertook the reorganization described in more detail in Note 3 on page 193 of the annual report (Segmentation of key figures 2016, 2015 and 2014).

Following the reorganization, management updated its assessment of the groups of cash generating units (CGUs) used as a basis for assessing goodwill and reallocated the goodwill amongst CGUs based on the relative fair values of the individual businesses.

The assessment of the carrying value of the goodwill balances is dependent on the estimation of future cash flows. In particular, those assessments and judgments made to support the carrying value of the goodwill allocated to the Alcon Division were critical, given the 2016 underlying results of Alcon.

Refer to Note 1 Significant accounting policies (pages 184 to 185) and Note 11 Goodwill and intangible assets (pages 207 to 208).

We assessed and tested the design and operating effectiveness of the Group’s controls over the assessment of the carrying value of goodwill and concluded that these operate effectively.

In relation to the reorganization we assessed the aggregation of CGUs through review of the relevant documents of the Executive Committee of Novartis (ECN) confirming that it is the lowest level at which management monitors goodwill for internal purposes and that no grouping of CGUs for goodwill impairment testing purposes is larger than any of the Group’s operating segments.

With respect to the reallocation of goodwill relating to the Ophthalmic Pharmaceuticals franchise, we tested the respective models determining the relative fair values of the businesses and the related goodwill focusing on the reasonableness of the key assumptions, including revenue and profitability growth, the success of new product launches, terminal values and discount rates, by challenging management to substantiate its assumptions and comparing them to the relevant industry and economic forecasts.

We tested, with the support of our valuation specialists, the carrying value of the goodwill allocated to Alcon as at December 31, 2016 focusing on the reasonableness of the cash flows growth rate after the forecast period assumption of 3%, given that this rate is above both the growth rate achieved by Alcon recently and the rate of inflation in key markets at the end of 2016. We also challenged management to substantiate its key assumptions in the cash flow projections during the forecast period and its intention and ability to execute their strategic initiatives and evaluated the reasonableness of the discount rate applied to those future cash flows.

We assessed management’s sensitivity analysis around key estimates to quantify the downside changes in assumptions that could result in an impairment and the disclosures included in Note 11 Goodwill and intangible assets (pages 207 to 208) of the annual report.

As a result of our procedures, as discussed with the Audit and Compliance Committee, we determined that the conclusions reached by management with regard to the carrying value of goodwill were reasonable and supportable.

 
5. Carrying value of intangible assets other than goodwill
Novartis – Extract from Audit Report of Financial Statement 2016
Key audit matter How our audit addressed the key audit matter

The Group has intangible assets other than goodwill totaling USD 31.3 billion at December 31, 2016, comprising research and development acquired, currently marketed products, marketing know-how, technologies, the Alcon brand name and other intangible assets. The Group recognized specific impairments of intangible assets other than goodwill of USD 591 million during the year.

The assessment of the carrying values of intangible assets is dependent on future cash flows and if these are below initial expectations there is a risk that the assets will be impaired. The reviews of carrying values performed by the Group contain a number of significant judgements and estimates such as scientific success, revenue growth, the success of new product launches, profit margins and discount rates.

The carrying value assessments of the following intangible assets includes the most significant risk and highest level of judgement:

  • The Alcon brand name is an indefinite life corporate asset and not subject to amortization.
  • Certain currently marketed products which have performed below management’s expectation or were, in our view, at a greater risk of impairment.
  • Products in development, as the assessment of their carrying value is challenging due to management being required to make judgements both as to the probability of scientific success and regulatory approval of the developments across indications, as well as the probability of commercial success of the subsequent product launches.

Refer to Note 1 Significant accounting policies (pages 184 to 185) and Note 11 Goodwill and intangible assets (pages 207 to 208).

We assessed and tested the design and operating effectiveness of the Group’s controls over the assessment of the carrying value of intangible asset other than goodwill and concluded that these operate effectively, specifically in respect to the identification of impairment triggering events.

We obtained the Group’s carrying value calculations and assessed the key assumptions. For the Alcon brand name and the currently marketed products these assumptions specifically included pricing, market size and share and competition assumptions.

In addition, for the assessment of the Alcon brand name we challenged the indefinite life designation of the asset considering the performance of the business in 2016 and the internal reorganization described in Note 3 on page 193 of the annual report (Segmentation of key figures 2016, 2015 and 2014). We discussed with the Audit and Compliance Committee and management their judgements and conclusion on the indefinite life designation of the Alcon brand name as well as their strategic initiatives.

For selected currently marketed products and products in development, with the support of our valuation specialists, we considered third party sources to challenge expected future revenues due to actions by competitors or due to changes in relevant markets.

Furthermore, for products in development we also considered key scientific developments. We performed our own sensitivity analysis around these key estimates to ascertain the extent of change in those assumptions that either individually or collectively would be required for the intangible assets tested to be impaired.

As a result of our procedures we did not propose any adjustments to the amount of impairment recognized in 2016. For those intangible assets where management determined that no impairment was required, we found that the assessments made by management were based upon reasonable assumptions, consistently applied.

 
6. Governmental investigations and litigations
Novartis – Extract from Audit Report of Financial Statement 2016
Key audit matter How our audit addressed the key audit matter

The pharmaceuticals industry is heavily regulated which increases inherent litigation risk.

The Group is subject to various government investigations, of which the most significant are disclosed in Note 20 Provisions and other non-current liabilities.

We specifically assessed the investigations and related litigations in the US given their significance and the inherent uncertainty of outcomes.

Refer to Note 1 Significant accounting policies on page 186 and Note 20 Provisions and other non-current liabilities (pages 216 to 220).

We assessed and tested the design and operating effectiveness of the Group’s controls over the completeness, assessment for recognition, measurement and disclosures of provisions for governmental investigations and other legal matters and concluded that these operate effectively.

We evaluated management’s judgments in connection with the investigations and related litigations in the US, read the respective court filings and minutes of Board of Directors and management meetings and inquired with the Audit and Compliance Committee, management, internal and external legal counsel.

We concluded that the judgements made by management were in accordance with the accounting policies described in Note 1.

 
7. Rebates, discounts, allowances and returns
Novartis – Extract from Audit Report of Financial Statement 2016
Key audit matter How our audit addressed the key audit matter

The Group distributes its products in many cases through wholesale distributors, however the ultimate net selling prices are determined based on the contractual arrangements that the Group has with the ultimate patient’s insurer or other payment program.

The initial revenue recognition, usually upon shipment to the distributor requires an estimate of the net selling price taking into consideration rebates and discounts as well as sales returns. The estimate depends on contract terms and regulation, as well as forecasts of sales volumes by sales channel. The dispensing of the product to the patient and the final determination of the selling price may be several months later.

We focused our testing on the accruals for both rebates and discounts together with sales returns recognized at the year end because, specifically for Medicaid and Medicare or equivalent programs in the US, the estimation processes involve large volumes of data, require significant judgement and can be at risk of management bias.

The provision reported as of December 31, 2016 for revenue deductions amounted to USD 4.2 billion.

Refer to Note 22 Provisions and other current liabilities (pages 221 and 222).

We performed procedures to assess the design and operating effectiveness of the controls related to the recording of rebates, discounts and sales returns and the estimation of related period end reserves.

We obtained management’s calculations for the respective estimates and performed one or more of the following procedures on each of them: developed an independent expectation of the reserve and/or tested management’s estimation process to assess the reasonableness of the recorded reserve balances, performed retrospective reviews and assessed subsequent events. We also performed testing of credits issued and payments made throughout the year, reviewed related contracts and independently confirmed sales terms with significant customers and inventory levels with the largest wholesalers.

We did not identify any material differences between our independent expectations and the accruals and we found the judgements made by management to be reasonable.