Licenses of intellectual property frequently include fees that are based on the customer’s subsequent usage of the IP or sale of products that contain the IP. The revenue standard includes an exception for the recognition of sales- or usage-based royalties promised in exchange for a license of IP.
Excerpt from ASC 606-10-55-65
This guidance is an exception to the general principles for accounting for variable consideration (refer to RR 4 for further discussion of variable consideration). The exception only applies to licenses of IP and should not be applied to other fact patterns by analogy. Further, reporting entities that sell, rather than license, IP cannot apply the sales- or usage-based royalty exception. Sales- or usage-based royalties received in arrangements other than licenses of IP should be estimated as variable consideration and included in the transaction price, subject to the constraint (refer to RR 4.3.2), and recognized when the related performance obligations are satisfied.
The above “later of” guidance for royalties is intended to prevent the recognition of revenue prior to a reporting entity satisfying its performance obligation. Royalties should be recognized as the underlying sales or usages occur, as long as this approach does not result in the acceleration of revenue ahead of the reporting entity’s performance. As noted in RR 9.5, the revenue standard does not prescribe a method for measuring a reporting entity’s performance for a right to access IP (that is, a license for which revenue is recognized over time). Management should therefore apply judgment to determine whether recognizing royalties due each period results in accelerating revenue recognition ahead of performance for a right to access IP. It may be appropriate, in some instances, to conclude that royalties due each period correlate directly with the value to the customer of the reporting entity’s performance.
Question RR 9-2 addresses the accounting for royalties promised in exchange for an in-substance sale of IP.
Question RR 9-2
How should reporting entities account for sales- or usage-based royalties promised in exchange for a license of IP that in substance is the sale of IP?
The exception for sales- or usage-based royalties applies to licenses of IP and not to sales of IP. The FASB noted in its basis for conclusions that a reporting entity should not distinguish between licenses and in-substance sales in deciding whether the royalty exception applies.
Question RR 9-3
Is a reporting entity permitted to recognize sales- or usage-based royalties prior to the period the sales or usages occur if management believes it has historical experience that is highly predictive of the amount of royalties that will be received?
No, application of the exception is not optional. Sales- or usage-based royalties in the scope of the exception cannot be recognized prior to the period the uncertainty is resolved (that is, when the customer’s subsequent sales or usages occur).
Question RR 9-4
Should sales- or usage-based royalties promised in exchange for a license of IP be recognized in the period the sales or usages occur or the period such sales or usages are reported by the customer (assuming the related performance obligation has been satisfied)?
The exception states that royalties should be recognized in the period the sales or usages occur (assuming the related performance obligation has been satisfied). It may therefore be necessary for management to estimate sales or usages that have occurred, but have not yet been reported by the customer.
Question RR 9-5
A reporting entity (an agent) distributes licenses of IP on behalf of the owner of the IP (the licensor). The reporting entity is a distribution agent and accordingly, performs an agency service for the licensor. The agent’s compensation is in the form of a specified percentage of the royalties the licensor receives from its customers. Those royalties are calculated based on the licensor’s customers’ sales (that is, a sales-based royalty). Can the agent also apply the exception for sales- or usage-based royalties?
We believe it would be acceptable for the agent to apply the exception for sales- or usage-based royalties. As discussed in BC415, applying the exception in this case is consistent with the reasons the boards concluded that reporting entities should not estimate royalties from licenses of IP and provided the royalty exception. Additionally, in this fact pattern, the service provided by the agent is directly related to the license of IP. Application of the sales- or usage-based royalty exception may not be appropriate in circumstances when a reporting entity receives a share of a royalty stream as compensation, but its performance is clearly unrelated to the license of IP.
We believe it would also be acceptable for the agent to conclude its fee is not subject to the exception for sales- or usage-based royalties. This conclusion would be based on the fact that the agent’s performance obligation is a service, not the license of IP. A reporting entity concluding its fee is not subject to the exception would apply the general guidance on variable consideration (including the variable consideration constraint) and recognize revenue as the service is performed, as opposed to recognizing revenue in the period the licensor’s customers’ sales occur. The reporting entity’s conclusion should be applied consistently to similar arrangements.
Question RR 9-6
Does the exception for sales- or usage-based royalties impact the determination of the transaction price (step 2) or the recognition of revenue (step 5)?
The sales- or usage-based royalty exception is a constraint on the recognition of revenue in step 5 of the revenue recognition model. That is, sales- or usage-based royalties are included in the transaction price as part of step 2, similar to other variable consideration, but recognition of the royalty in step 5 is precluded prior to the period the sales or usages occur. This concept is illustrated in Example 35 of the revenue standard (ASC 606-10-55-270 through ASC 606-10-55-279). Often, it is not necessary to estimate royalties at contract inception because the exception precludes recognition prior to the period the sales or usages occur. However, in some instances, it may be necessary to estimate royalties as part of determining and allocating the transaction price. For example, it may be necessary to estimate royalties to apply the guidance on allocating variable consideration (refer to RR 5.5.1) or when accounting for arrangements that include minimum royalties (refer to RR 9.8.3).
Question RR 9-7
A reporting entity licenses functional IP to a customer in exchange for a sales-based royalty and concludes that its performance obligation is satisfied when the license period begins. The calculation of the sales-based royalty is based on a royalty rate that decreases over the term of the contract. Should the reporting entity calculate an average royalty rate to determine the amount of revenue to recognize when the customer’s subsequent sales occur?
No. Under the sales- or usage-based royalty exception, the amount included in the transaction price is the contractually-specified royalty amount. Since the related performance obligation has already been satisfied in this scenario, revenue is recognized once the consideration is no longer contingent on future sales. Therefore, revenue should be recognized once the sale occurs regardless of the rate or method used to calculate the royalty.