12.2 Scope of the Licensing Guidance

ASC 606-10

55-54 A license establishes a customer’s rights to the intellectual property of an entity. Licenses of intellectual property may include, but are not limited to, licenses of any of the following:

Software (other than software subject to a hosting arrangement that does not meet the criteria in paragraph 985-20-15-5) and technology
Motion pictures, music, and other forms of media and entertainment
Franchises
Patents, trademarks, and copyrights.

Although the guidance above provides examples of licenses of IP, the term “intellectual property” is not formally defined in U.S. GAAP. However, paragraph BC51 of ASU 2016-10 states that “intellectual property is inherently different from other goods or services because of its uniquely divisible nature,” noting that “intellectual property can be licensed to multiple customers at the same time . . . and can continue to be used by the entity during the license period for its own benefit.” Identification of IP will require judgment.

Connecting the Dots

The licensing guidance in the revenue standard applies to licenses of IP that are an output of an entity’s ordinary activities (and, therefore, contracts to provide licenses of IP to customers). In some instances, an entity whose ordinary activities do not involve the licensing of IP may enter into a contract to provide a license of IP to a third party. Because the contract is not with a customer, the licensing guidance in the revenue standard is not directly applicable. Further, because a derecognition event does not occur in a licensing transaction (i.e., there is no sale of the IP itself), the guidance in ASC 610-20 on accounting for gains and losses on the derecognition of nonfinancial assets is also not directly applicable. That is, a license of IP is outside the scope of ASC 610-20 since the license does not result in the transfer of the underlying IP when the entity still controls the IP (see Section 12.2.2 for more information about distinguishing between a license and an in-substance sale of IP).

We believe that an entity could apply the licensing guidance in the revenue standard by analogy to account for the measurement and recognition of licenses of IP that are outside the scope of ASC 606 (i.e., licenses of IP that are not an output of the entity’s ordinary activities). For example, an entity could apply ASC 606 to determine whether a license of IP to a noncustomer represents a license to functional or symbolic IP. In addition, a license of IP to a noncustomer could include sales- or usage-based royalties, in which case an entity could apply the sales- or usage-based royalty exception in ASC 606. However, while an entity could apply aspects of ASC 606 by analogy, any gain or loss should not be presented or disclosed as revenue from contracts with customers.

If an entity entered into an agreement with a noncustomer to sell the underlying IP instead of licensing the IP (i.e., the entity transferred control of the IP and derecognized it), the sale would be within the scope of ASC 610-20. In that case, the sales- or usage-based royalty exception would not apply (because the exception applies only to licenses of IP). Rather, the entity would need to estimate and constrain royalties when determining the gain or loss it should record on the transfer of control of the IP.

12.2.1 Software in a Hosting Arrangement

Software in a hosting arrangement is excluded from the scope of the licensing guidance in the revenue standard unless both of the following criteria in ASC 985-20-15-5 are met:

The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty.
It is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.

Connecting the Dots

Some may question whether “at any time” during the hosting period means at every point in time during the hosting period. We do not believe that to be the case. For example, an entity’s arrangements may specify that the customer will automatically obtain the software at the end of the hosting period. We believe that as long as the customer can take possession of the software at that point without significant penalty and it is feasible for the customer to run the software (either on its own or with a third-party vendor), the software license is a separate promise in the hosting arrangement and would therefore meet the criteria in ASC 985-20-15-5(a) and (b).

Many software hosting arrangements include a “license” to software but allow the customer to use the software only in the entity’s (rather than the customer’s) hosted environment (because of contractual or practical limitations, or both). Although these arrangements may include a contractual license, since the customer is unable to take possession of the software subject to the license without significant penalty, the customer is required to make a separate buying decision before control of any software is truly transferred to the customer (the separate buying decision would be the customer’s election to incur the penalty to take possession of the software). These transactions are accounted for as service transactions (rather than licensing transactions) since the entity is providing the functionality of the software through a hosting arrangement (service) rather than through an actual software license that is controlled by the customer.

Connecting the Dots

It is common for software to be hosted on the platform or infrastructure of a third party rather than that of the vendor or customer. In these circumstances, it is important to determine who has the contract with the third party (i.e., whether it is the vendor’s or customer’s cloud instance4 of the third-party platform or infrastructure). If the software is hosted on the customer’s cloud instance, the customer has possession of the software, and the arrangement would be subject to the licensing guidance in the revenue standard. By contrast, if the software is hosted on the vendor’s cloud instance and the customer cannot otherwise obtain possession of the software without significant penalty, the software is provided in a hosting arrangement and is excluded from the licensing guidance in the revenue standard.

Example 12-1

Entity L, a software vendor, offers its office productivity package in an online format whereby a user accesses a Web site and stores files on a secure server. The applications will always be maintained at the most up-to-date version available, and customers have rights to online and telephone support. The customer will pay a fee of $200 for a one-year “right to use” license for software. Renewal fees are $200 for each subsequent year renewed. The customer does not have the ability to take possession of the software.

The license cannot be unbundled from the hosting service because the customer is not permitted to take possession and may only use the software together with L’s hosting service. Therefore, the criteria in ASC 985-20-15-5 are not met, and the arrangement consequently does not contain a license as described in ASC 606-10-55-54. Entity L should recognize the $200 over the one-year term of the arrangement once the customer has access to the hosted software.

As noted above, to determine whether a right to use software in a hosted environment includes a license within the scope of the revenue standard’s licensing guidance, entities need to consider whether the software license is within the scope of ASC 985-20. For the software subject to a hosting arrangement to be within the scope of ASC 985-20 (and, therefore, within the scope of the licensing guidance in the revenue standard), the criteria in ASC 985-20-15-5(a) and (b) must both be met.

ASC 985-20-15-6 states that the term “significant penalty” as used in ASC 985-20-15-5(a) contains the following two distinct concepts:

The ability to take delivery of the software without incurring significant cost
The ability to use the software separately without a significant diminution in utility or value.

The analysis for determining whether either or both of these conditions are met (i.e., a significant penalty exists) depends on the facts and circumstances of the arrangement and requires judgment. An entity may consider the following factors (not all-inclusive) in making this assessment:

Contractual cancellation fees associated with the hosting arrangement.
Other contractual penalties for taking possession of the software (e.g., the requirement that the customer continue to pay the hosting fees for the remainder of the hosting term even though hosting services are terminated).
Costs of transitioning to (1) use of the software on the customer’s own servers or (2) hosting of the software by the customer’s third-party vendor.
Whether the utility and value of the software can be maintained upon transition (e.g., whether (1) the customer will continue to receive updates, upgrades, and enhancements and (2) the software will be capable of providing the same functionality in another environment).
Whether the software (1) has stand-alone functionality (on its own or with readily available resources) or (2) is significantly tied to other products or services that can be provided only by the entity and will no longer be provided if the customer takes possession of the software.

Significance can be evaluated both quantitatively and qualitatively. The accounting literature does not contain specific guidance on (1) which elements of the contract should be included in the measurement of the amount of the penalty or (2) the benchmark against which the entity should measure the amount of the penalty when determining whether the penalty is quantitatively significant. An entity may have an established policy for determining whether the penalty is significant. For example, in a manner consistent with other Codification subtopics, the entity may reasonably conclude that amounts above 10 percent of a given benchmark are significant. Establishing a method of determining both the elements of the contract to include in the measurement of the penalty and the benchmark against which to measure the penalty is an accounting policy decision that the entity should apply consistently.

The examples below illustrate how an entity might evaluate the existence of a significant penalty. However, there are no bright lines, and entities will need to use judgment when establishing policies.

Example 12-1A

Company X and Customer Y enter into a three-year software and hosting arrangement in which X allows Y to access X’s software via the Internet and use the software that X physically hosts on its servers. Customer Y is required to pay a nonrefundable up-front license fee of $500,000 at the inception of the arrangement and make monthly payments of $25,000 for the hosting services that X provides.

As part of the arrangement, Y has the right to take possession of the software at any time during the contract period by paying a conversion fee equal to six months of the hosting services. That is, to take possession of the software on day 1, Y will have to pay $150,000 in hosting service fees to X (calculated as $25,000 × 6 months). If Y takes possession of the software, the core functionality of the software will remain available to Y. In addition, Y is expected to have the capacity and resources to host the software on its own servers without incurring additional costs. Company X has a policy of measuring the significance of a penalty by comparing the conversion fee with the total noncancelable contract value (i.e., by determining the percentage of the total noncancelable contract value that the conversion fee represents).

Although Y (1) will not experience significant diminution in utility or value of the software if it takes possession of the software on day 1 and (2) is expected to have the resources to run the software on its own, X evaluates whether Y will incur a significant penalty by comparing the conversion fee ($150,000) with the noncancelable contract fee ($500,000 nonrefundable up-front license fee + $150,000 conversion fee). Company X performs the calculation as follows:

$150,000 ÷ ($500,000 + $150,000) = $150,000 ÷ $650,000 = 23%.

Company X concludes that the penalty is significant. Consequently, the software and hosting arrangement does not contain a license and would be accounted for as a SaaS (or service) arrangement.

Example 12-2

Company E is developing a customer relationship management (CRM) software solution to be marketed and sold to customers. The software will be provided to customers on a hosted basis (i.e., the software will be accessed by using an Internet connection) and will connect to E’s proprietary data analytics platform, which has already been developed and is housed on E’s own servers (i.e., it is a software as a service [SaaS] solution that is accessed only online). Company E’s data analytics platform will be a significant part of the overall solution sold to its customers and will be significantly integrated with the CRM software solution being developed. Company E plans to provide its customers with the contractual ability to take possession of the CRM software on an on-premise basis, when requested at any point during the hosting period, without paying E a penalty or cancellation fee. However, customers will not have the contractual ability to take possession of E’s data analytics platform. In addition, cancellation of the hosting service for the CRM software will also result in the cancellation of the SaaS for E’s data analytics platform, which cannot be easily replicated by the customer or third-party vendors. Further, customers would incur significant costs to integrate the CRM software with other third-party data analytics platforms.

While a customer will have “the contractual right to take possession of the software at any time during the hosting period” without paying E a penalty or cancellation fee, it cannot do so without incurring a significant penalty (i.e., significant diminution in utility or value of the CRM software without E’s data analytics platform). Therefore, E concludes that arrangements with customers for the CRM software solution do not meet the criteria to be accounted for as licensing arrangements.

12.2.2 License Versus In-Substance Sale of IP

Other scope-related questions may require judgment. For example, stakeholders have raised concerns regarding the evaluation of whether certain licensing arrangements that are in-substance sales of IP should be accounted for as sales of IP (under either the guidance in ASC 606 unrelated to licenses if the sales arise from contracts with customers [see Chapter 4] or the guidance in ASC 610-20 on sales of nonfinancial assets if the sales are transactions with noncustomers [see Chapter 17]) or as licenses of IP. For example, an entity may license IP to a customer under an arrangement that gives the customer exclusive use of the IP for either a perpetual term or a period that is substantially the same as the IP’s useful life.

Stakeholders have questioned whether these arrangements would be within the scope of (1) the licensing implementation guidance discussed in this chapter or (2) the general recognition and measurement model in the revenue standard, which could result in a different pattern of revenue recognition. Specifically, concerns have been raised about the application of the sales- or usage-based royalty exception (see Section 12.7). The FASB considered, but rejected, expanding the scope of the royalty recognition constraint because of complexities in legal differences between a sale of IP and a license of IP. More specifically, the FASB noted in the Background Information and Basis for Conclusions of ASU 2016-10 that an entity should not distinguish between licenses and in-substance sales in deciding whether the royalty exception applies. We generally believe that the legal form of the transaction will determine which revenue accounting guidance (i.e., the guidance on estimating royalties or the guidance on applying the royalty recognition constraint) is applicable. For discussion of the scope of the sales- or usage-based royalty exception, see Section 12.7.3.

12.2.3 Sales of Books, Recorded Music, and Similar Items

In many industries, it is common for an entity to sell a tangible product (e.g., a DVD, CD, or hard-copy book) that contains IP such as a movie, music, or a novel (a “copyrighted work”).

The “first sale doctrine”5 provides that an individual who purchases a copy of a copyrighted work from the copyright holder is the owner of that individual copy and receives the right to sell, lease, or otherwise dispose of that particular copy without the permission of the copyright owner. Therefore, the owner of an individual copy of IP controls the economic benefits of that copy of the copyrighted work. However, the owner of the copy has no right to the underlying copyright in the work and has only purchased use of that specific instance of the copyrighted work. While the term “first sale doctrine” is specific to U.S. law, many other jurisdictions have similar regulations related to copyrighted work.

An entity should not apply the implementation guidance on licenses in ASC 606-10-55-54 through 55-65B to sales of goods subject to the first sale doctrine or other similar jurisdictional regulations. Rather, such transactions should be considered sales of goods rather than licenses of IP.

Although there is a license to the IP incorporated in the good, the contract with the customer is an arrangement for the sale of a good (e.g., a single, physical copy of a book) rather than the IP. That is, sales of goods subject to the first sale doctrine should be evaluated as sales of tangible goods rather than licenses of IP since the original purchaser of the goods relinquishes all rights to the underlying IP if it sells or otherwise transfers the associated goods to another party. As a result, the general guidance in ASC 606 should be applied to such sales in the same way it is applied to other sales of goods.

In instances in which the entity also promises to provide the customer with the right to download a digital copy of the IP (e.g., a movie or song) that may be installed on a mobile device and this digital copy is subject to certain restrictive licensing terms and conditions that result in the inability to transfer the downloaded content to another party (i.e., the digital copy is not subject to the first sale doctrine), the entity should assess whether the promise to provide the download right is distinct. If the promise is distinct, the entity should apply the implementation guidance on licenses in ASC 606-10-55-58 through 55-65B.

Footnotes

When used in the context of cloud capacity, the term “cloud instance” refers to the cloud environment in which the software operates.

The first sale doctrine, codified in 17 U.S.C. Section 109, provides that an individual who knowingly purchases a copy of a copyrighted work from the copyright holder receives the right to sell, display, or otherwise dispose of that particular copy notwithstanding the interests of the copyright owner. However, the right to distribute ends once the owner has sold that particular copy (see 17 U.S.C. Sections 109(a) and 109(c)). Since the first sale doctrine never protects a defendant who makes unauthorized reproductions of a copyrighted work, the first sale doctrine cannot be a successful defense in cases that allege infringing reproduction. Further, 17 U.S.C. Section 109(d) provides that the privileges created by the first sale principle do not “extend to any person who has acquired possession of the copy or phonorecord from the copyright owner, by rental, lease, loan, or otherwise, without acquiring ownership of it.” Most computer software is distributed through the use of licensing agreements. Under this distribution system, the copyright holder remains the “owner” of all distributed copies. For this reason, alleged infringers should not be able to establish that any copies of these works have been the subject of a first sale. That is, sales of software will typically not be subject to the first sale doctrine.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.