3. Critical accounting estimates and judgments

In the application of the accounting policies, we are required to make judgments, estimates and assumptions about the carrying amounts of assets and liabilities that are not readily apparent from other sources. The estimates and associated assumptions are based on historical experience and other factors that are considered to be relevant. Actual results may differ from these estimates.

Our estimates and assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimate is revised if the revision affects only that period or in the period of the revisions and future periods if the revision affects both current and future periods.

Drafting financial statements in accordance with IFRS requires management to make judgments and estimates and to use assumptions that influence the reported amounts of assets and liabilities, the notes on contingent assets and liabilities on the date of the financial statements and the reported amounts of income and expenses during the reporting period. Actual results may differ from these estimates.

The following are the critical judgments and estimates that we have made in the process of applying the accounting policies and that have the most significant effect on the amounts recognized in the consolidated financial statements presented elsewhere in this Annual Report.

Critical judgments in applying accounting policies

Share subscription agreement with Gilead – classification as derivative financial asset or equity instrument

As described in note 8, Gilead Sciences, Inc. (“Gilead”) committed itself on 16 December 2015 to make a $425 million equity investment in Galapagos by subscribing to new shares at a fixed price of €58 per share, including issuance premium upon completion of the license and collaboration agreement with Galapagos that took place on 19 January 2016.

Significant judgment had to be applied in assessing whether this forward subscription commitment of Gilead over the own shares of Galapagos shall be classified as an own equity instrument of Galapagos or as a derivative financial asset. IAS 32 requires that for a derivative to meet the definition of equity it must be settled only by the issuer (Galapagos) exchanging a “fixed amount of cash or another financial asset for a fixed number of its own equity instruments”. Because the above mentioned commitment of Gilead was made in $, the actual number of shares finally issued by Galapagos varied with the fluctuation in the $/€ exchange rate until the settlement date on 19 January 2016.

Despite the fact that this foreign exchange exposure is limited, management judged that this variability prevents the instrument from being classified as equity under IAS 32 and is therefore treated as a derivative at fair value through profit and loss.

Revenue recognition

Evaluating the criteria for revenue recognition with respect to our research and development and collaboration agreements requires management’s judgment to ensure that all criteria have been fulfilled prior to recognizing any amount of revenue. In particular, such judgments are made with respect to determination of the nature of transactions, whether simultaneous transactions shall be considered as one or more revenue-generating transactions, allocation of the contractual price (upfront and milestone payments in connection with a collaboration agreement) to several elements included in an agreement, and the determination of whether the significant risks and rewards have been transferred to the buyer. Collaboration agreements are reviewed carefully to understand the nature of risks and rewards of the arrangement. All of our revenue-generating transactions have been subject to such evaluation by management.

Critical accounting estimates

Fair value re-measurement of the Gilead share subscription agreement (derivative financial asset instrument)

The fair value measurement of this derivative financial asset is categorized as a level 3 in the fair value hierarchy of IFRS 13 Fair Value Measurement.

Its measurement is based on computing the difference between the strike price (€58/ share) and the anticipated Galapagos forward price, discounted to the valuation date. The notional is converted from USD to EUR by the currency exchange forward rate and the number of shares is computed by dividing the EUR notional by the strike.

Input data are taken from Bloomberg as of 16 December 2015 and 31 December 2015, including:

• EUR OIS Discount rates (curve 133)
• Implied forward rate of the GLPG share at 31 January 2016
• Implied FX Forward rate at 31 January 2016

This computation is based on the following unobservable assumptions:

• Between the date that the deal is signed (16 December 2015) until the date the deal is complete, the two counterparties cannot back off from the deal and it is 100% certain that the U.S. Federal Trade Commission will give the green light
• At the two valuation dates, it is assumed that the date when the deal will be complete will be 31 January 2016. This is the forward date from where all the market data is taken from
• It is assumed that the effect of the correlation between the Galapagos share price and the EUR/USD currency exchange rate is negligible. This is reasonable given the very short maturity of the deal

Relationship of unobservable inputs to the fair value measurement:

• If one would have assumed that the closing date of the deal was 19 January 2016 (the actual closing date) the fair value of the derivative financial asset at 31 December 2015 would have been €8,367 thousand.

Recognition of clinical trial expenses

We recognize expenses incurred in carrying out clinical trials during the course of each clinical trial in line with the state of completion of each trial. This involves the calculation of clinical trial accruals at each period end to account for incurred expenses. This requires estimation of the expected full cost to complete the trial as well as the current stage of trial completion.

Clinical trials usually take place over extended time periods and typically involve a set-up phase, a recruitment phase and a completion phase which ends upon the receipt of a final report containing full statistical analysis of trial results. Accruals are prepared separately for each clinical trial in progress and take into consideration the stage of completion of each trial including the number of patients that have entered the trial and whether the final report has been received. In all cases, the full cost of each trial is expensed by the time the final report is received. There have not been any material adjustments to estimates based on the actual costs incurred for each period presented.

Share-based payments plans

We determine the costs of the share-based payments plans (warrant plans) on the basis of the fair value of the equity instrument at grant date. Determining the fair value assumes choosing the most suitable valuation model for these equity instruments, by which the characteristics of the grant have a decisive influence. This assumes also the input into the valuation model of some relevant judgments, like the estimated expected life of the warrant and the volatility. The judgments made and the model used are further specified in note 30.

Pension obligations

The cost of a defined pension arrangement is determined based on actuarial valuations. An actuarial valuation assumes the estimation of discount rates, estimated returns on assets, future salary increases, mortality figures and future pension increases. Because of the long term nature of these pension plans, the valuation of these is subject to important uncertainties. See note 29 for additional details.

Corporate income taxes

Significant judgment is required in determining the use of tax loss carry forwards. Deferred tax assets arising from unused tax losses or tax credits are only recognized to the extent that there are sufficient taxable temporary differences or there is convincing evidence that sufficient taxable profit will be available against which the unused tax losses or unused tax credits can be utilized. Management’s judgment is that such convincing evidence is currently not sufficiently available except for two subsidiaries operating intercompany on a cost plus basis and as such a deferred tax asset is therefore recognized. As of 31 December 2015, we had a total of approximately €265 million of statutory tax losses carried forward which can be compensated with future taxable statutory profits for an indefinite period except for an amount of €17 million in Switzerland, Croatia, the United States and The Netherlands with expiry date between 2018 and 2030. As of 31 December 2015, the available tax losses carried forward in Belgium amounted to €184 million.