12.3 Identifying Performance Obligations

Licenses are often included with other goods or services in a contract. An entity will need to use judgment in determining whether a license (1) is distinct or (2) should be combined with other promised goods and services in the contract as a single performance obligation. An entity would apply the guidance in ASC 606-10-25-14 through 25-22 in identifying the performance obligations in the contract. The licensing implementation guidance is applicable to arrangements with customers that contain (1) a distinct license or (2) a license that is the predominant promised item in a performance obligation involving multiple goods or services.

ASC 606-10

55-55 In addition to a promise to grant a license (or licenses) to a customer, an entity may also promise to transfer other goods or services to the customer. Those promises may be explicitly stated in the contract or implied by an entity’s customary business practices, published policies, or specific statements (see paragraph 606-10-25-16). As with other types of contracts, when a contract with a customer includes a promise to grant a license (or licenses) in addition to other promised goods or services, an entity applies paragraphs 606-10-25-14 through 25-22 to identify each of the performance obligations in the contract.

55-56 If the promise to grant a license is not distinct from other promised goods or services in the contract in accordance with paragraphs 606-10-25-18 through 25-22, an entity should account for the promise to grant a license and those other promised goods or services together as a single performance obligation. Examples of licenses that are not distinct from other goods or services promised in the contract include the following:

A license that forms a component of a tangible good and that is integral to the functionality of the good
A license that the customer can benefit from only in conjunction with a related service (such as an online service provided by the entity that enables, by granting a license, the customer to access content).

55-57 When a single performance obligation includes a license (or licenses) of intellectual property and one or more other goods or services, the entity considers the nature of the combined good or service for which the customer has contracted (including whether the license that is part of the single performance obligation provides the customer with a right to use or a right to access intellectual property in accordance with paragraphs 606-10-55-59 through 55-60 and 606-10-55-62 through 55-64A) in determining whether that combined good or service is satisfied over time or at a point in time in accordance with paragraphs 606-10-25-23 through 25-30 and, if over time, in selecting an appropriate method for measuring progress in accordance with paragraphs 606-10-25-31 through 25-37.

When a license is included in an arrangement to provide additional goods or services, determining whether the license is distinct may require significant judgment. An entity would need to carefully evaluate whether the license is both capable of being distinct and distinct in the context of the contract. See Chapter 5 for additional considerations related to identifying performance obligations.

The Codification examples below illustrate how an entity would apply the guidance on determining whether multiple goods and services promised in the entity’s contract, including a license, are distinct.

ASC 606-10

Example 10 — Goods and Services Are Not Distinct

[Cases A and B omitted6]

Case C — Combined Item

55-140D An entity grants a customer a three-year term license to anti-virus software and promises to provide the customer with when-and-if available updates to that software during the license period. The entity frequently provides updates that are critical to the continued utility of the software. Without the updates, the customer’s ability to benefit from the software would decline significantly during the three-year arrangement.

55-140E The entity concludes that the software and the updates are each promised goods or services in the contract and are each capable of being distinct in accordance with paragraph 606-10-25-19(a). The software and the updates are capable of being distinct because the customer can derive economic benefit from the software on its own throughout the license period (that is, without the updates the software would still provide its original functionality to the customer), while the customer can benefit from the updates together with the software license transferred at the outset of the contract.

55-140F The entity concludes that its promises to transfer the software license and to provide the updates, when-and-if available, are not separately identifiable (in accordance with paragraph 606-10-25-19(b)) because the license and the updates are, in effect, inputs to a combined item (anti-virus protection) in the contract. The updates significantly modify the functionality of the software (that is, they permit the software to protect the customer from a significant number of additional viruses that the software did not protect against previously) and are integral to maintaining the utility of the software license to the customer. Consequently, the license and updates fulfill a single promise to the customer in the contract (a promise to provide protection from computer viruses for three years). Therefore, in this Example, the entity accounts for the software license and the when-and-if available updates as a single performance obligation. In accordance with paragraph 606-10-25-33, the entity concludes that the nature of the combined good or service it promised to transfer to the customer in this Example is computer virus protection for three years. The entity considers the nature of the combined good or service (that is, to provide anti-virus protection for three years) in determining whether the performance obligation is satisfied over time or at a point in time in accordance with paragraphs 606-10-25-23 through 25-30 and in determining the appropriate method for measuring progress toward complete satisfaction of the performance obligation in accordance with paragraphs 606-10-25-31 through 25-37.

Example 11 — Determining Whether Goods or Services Are Distinct

Case A — Distinct Goods or Services

55-141 An entity, a software developer, enters into a contract with a customer to transfer a software license, perform an installation service, and provide unspecified software updates and technical support (online and telephone) for a two-year period. The entity sells the license, installation service, and technical support separately. The installation service includes changing the web screen for each type of user (for example, marketing, inventory management, and information technology). The installation service is routinely performed by other entities and does not significantly modify the software. The software remains functional without the updates and the technical support.

55-142 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity observes that the software is delivered before the other goods and services and remains functional without the updates and the technical support. The customer can benefit from the updates together with the software license transferred at the outset of the contract. Thus, the entity concludes that the customer can benefit from each of the goods and services either on their own or together with the other goods and services that are readily available and the criterion in paragraph 606-10-25-19(a) is met.

55-143 The entity also considers the principle and the factors in paragraph 606-10-25-21 and determines that the promise to transfer each good and service to the customer is separately identifiable from each of the other promises (thus, the criterion in paragraph 606-10-25-19(b) is met). In reaching this determination the entity considers that although it integrates the software into the customer’s system, the installation services do not significantly affect the customer’s ability to use and benefit from the software license because the installation services are routine and can be obtained from alternate providers. The software updates do not significantly affect the customer’s ability to use and benefit from the software license because, in contrast with Example 10 (Case C), the software updates in this contract are not necessary to ensure that the software maintains a high level of utility to the customer during the license period. The entity further observes that none of the promised goods or services significantly modify or customize one another and the entity is not providing a significant service of integrating the software and the services into a combined output. Lastly, the entity concludes that the software and the services do not significantly affect each other and, therefore, are not highly interdependent or highly interrelated because the entity would be able to fulfill its promise to transfer the initial software license independent from its promise to subsequently provide the installation service, software updates, or technical support.

55-144 On the basis of this assessment, the entity identifies four performance obligations in the contract for the following goods or services:

The software license
An installation service
Software updates
Technical support.

55-145 The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether each of the performance obligations for the installation service, software updates, and technical support are satisfied at a point in time or over time. The entity also assesses the nature of the entity’s promise to transfer the software license in accordance with paragraphs 606-10-55-59 through 55-60 and 606-10-55-62 through 55-64A (see Example 54 in paragraphs 606-10-55-362 through 55-363B).

Case B — Significant Customization

55-146 The promised goods and services are the same as in Case A, except that the contract specifies that, as part of the installation service, the software is to be substantially customized to add significant new functionality to enable the software to interface with other customized software applications used by the customer. The customized installation service can be provided by other entities.

55-147 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity first assesses whether the criterion in paragraph 606-10-25-19(a) has been met. For the same reasons as in Case A, the entity determines that the software license, installation, software updates, and technical support each meet that criterion. The entity next assesses whether the criterion in paragraph 606-10-25-19(b) has been met by evaluating the principle and the factors in paragraph 606-10-25-21. The entity observes that the terms of the contract result in a promise to provide a significant service of integrating the licensed software into the existing software system by performing a customized installation service as specified in the contract. In other words, the entity is using the license and the customized installation service as inputs to produce the combined output (that is, a functional and integrated software system) specified in the contract (see paragraph 606-10-25-21(a)). The software is significantly modified and customized by the service (see paragraph 606-10-25-21(b)). Consequently, the entity determines that the promise to transfer the license is not separately identifiable from the customized installation service and, therefore, the criterion in paragraph 606-10-25-19(b) is not met. Thus, the software license and the customized installation service are not distinct.

55-148 On the basis of the same analysis as in Case A, the entity concludes that the software updates and technical support are distinct from the other promises in the contract.

55-149 On the basis of this assessment, the entity identifies three performance obligations in the contract for the following goods or services:

Software customization which is comprised of the license to the software and the customized installation service
Software updates
Technical support.

55-150 The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether each performance obligation is satisfied at a point in time or over time and paragraphs 606-10-25-31 through 25-37 to measure progress toward complete satisfaction of those performance obligations determined to be satisfied over time. In applying those paragraphs to the software customization, the entity considers that the customized software to which the customer will have rights is functional intellectual property and that the functionality of that software will not change during the license period as a result of activities that do not transfer a good or service to the customer. Therefore, the entity is providing a right to use the customized software. Consequently, the software customization performance obligation is completely satisfied upon completion of the customized installation service. The entity considers the other specific facts and circumstances of the contract in the context of the guidance in paragraphs 606-10-25-23 through 25-30 in determining whether it should recognize revenue related to the single software customization performance obligation as it performs the customized installation service or at the point in time the customized software is transferred to the customer.

Example 55 — License of Intellectual Property

55-364 An entity enters into a contract with a customer to license (for a period of three years) intellectual property related to the design and production processes for a good. The contract also specifies that the customer will obtain any updates to that intellectual property for new designs or production processes that may be developed by the entity. The updates are integral to the customer’s ability to derive benefit from the license during the license period because the intellectual property is used in an industry in which technologies change rapidly.

55-365 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity determines that the customer can benefit from (a) the license on its own without the updates and (b) the updates together with the initial license. Although the benefit the customer can derive from the license on its own (that is, without the updates) is limited because the updates are integral to the customer’s ability to continue to use the intellectual property in an industry in which technologies change rapidly, the license can be used in a way that generates some economic benefits. Therefore, the criterion in paragraph 606-10-25-19(a) is met for the license and the updates.

55-365A The fact that the benefit the customer can derive from the license on its own (that is, without the updates) is limited (because the updates are integral to the customer’s ability to continue to use the license in the rapidly changing technological environment) also is considered in assessing whether the criterion in paragraph 606-10-25-19(b) is met. Because the benefit that the customer could obtain from the license over the three-year term without the updates would be significantly limited, the entity’s promises to grant the license and to provide the expected updates are, in effect, inputs that, together fulfill a single promise to deliver a combined item to the customer. That is, the nature of the entity’s promise in the contract is to provide ongoing access to the entity’s intellectual property related to the design and production processes for a good for the three-year term of the contract. The promises within that combined item (that is, to grant the license and to provide when-and-if available updates) are therefore not separately identifiable in accordance with the criterion in paragraph 606-10-25-19(b).

55-366 The nature of the combined good or service that the entity promised to transfer to the customer is ongoing access to the entity’s intellectual property related to the design and production processes for a good for the three-year term of the contract. Based on this conclusion, the entity applies paragraphs 606-10-25-23 through 25-30 to determine whether the single performance obligation is satisfied at a point in time or over time and paragraphs 606-10-25-31 through 25-37 to determine the appropriate method for measuring progress toward complete satisfaction of the performance obligation. The entity concludes that because the customer simultaneously receives and consumes the benefits of the entity’s performance as it occurs, the performance obligation is satisfied over time in accordance with paragraph 606-10-25-27(a) and that a time-based input measure of progress is appropriate because the entity expects, on the basis of its relevant history with similar contracts, to expend efforts to develop and transfer updates to the customer on a generally even basis throughout the three-year term.

Example 56 — Identifying a Distinct License

55-367 An entity, a pharmaceutical company, licenses to a customer its patent rights to an approved drug compound for 10 years and also promises to manufacture the drug for the customer for 5 years, while the customer develops its own manufacturing capability. The drug is a mature product; therefore, there is no expectation that the entity will undertake activities to change the drug (for example, to alter its chemical composition). There are no other promised goods or services in the contract.

Case A — License Is Not Distinct

55-368 In this case, no other entity can manufacture this drug while the customer learns the manufacturing process and builds its own manufacturing capability because of the highly specialized nature of the manufacturing process. As a result, the license cannot be purchased separately from the manufacturing service.

55-369 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity determines that the customer cannot benefit from the license without the manufacturing service; therefore, the criterion in paragraph 606-10-25-19(a) is not met. Consequently, the license and the manufacturing service are not distinct, and the entity accounts for the license and the manufacturing service as a single performance obligation.

55-370 The nature of the combined good or service for which the customer contracted is a sole sourced supply of the drug for the first five years; the customer benefits from the license only as a result of having access to a supply of the drug. After the first five years, the customer retains solely the right to use the entity’s functional intellectual property (see Case B, paragraph 606-10-55-373), and no further performance is required of the entity during Years 6–10. The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether the single performance obligation (that is, the bundle of the license and the manufacturing service) is a performance obligation satisfied at a point in time or over time. Regardless of the determination reached in accordance with paragraphs 606-10-25-23 through 25-30, the entity’s performance under the contract will be complete at the end of Year 5.

Case B — License Is Distinct

55-371 In this case, the manufacturing process used to produce the drug is not unique or specialized, and several other entities also can manufacture the drug for the customer.

55-372 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct, and it concludes that the criteria in paragraph 606-10-25-19 are met for each of the license and the manufacturing service. The entity concludes that the criterion in paragraph 606-10-25-19(a) is met because the customer can benefit from the license together with readily available resources other than the entity’s manufacturing service (that is, because there are other entities that can provide the manufacturing service) and can benefit from the manufacturing service together with the license transferred to the customer at the start of the contract.

55-372A The entity also concludes that its promises to grant the license and to provide the manufacturing service are separately identifiable (that is, the criterion in paragraph 606-10-25-19(b) is met). The entity concludes that the license and the manufacturing service are not inputs to a combined item in this contract on the basis of the principle and the factors in paragraph 606-10-25-21. In reaching this conclusion, the entity considers that the customer could separately purchase the license without significantly affecting its ability to benefit from the license. Neither the license nor the manufacturing service is significantly modified or customized by the other, and the entity is not providing a significant service of integrating those items into a combined output. The entity further considers that the license and the manufacturing service are not highly interdependent or highly interrelated because the entity would be able to fulfill its promise to transfer the license independent of fulfilling its promise to subsequently manufacture the drug for the customer. Similarly, the entity would be able to manufacture the drug for the customer even if the customer had previously obtained the license and initially utilized a different manufacturer. Thus, although the manufacturing service necessarily depends on the license in this contract (that is, the entity would not contract for the manufacturing service without the customer having obtained the license), the license and the manufacturing service do not significantly affect each other. Consequently, the entity concludes that its promises to grant the license and to provide the manufacturing service are distinct and that there are two performance obligations:

License of patent rights
Manufacturing service.

55-373 The entity assesses the nature of its promise to grant the license. The entity concludes that the patented drug formula is functional intellectual property (that is, it has significant standalone functionality in the form of its ability to treat a disease or condition). There is no expectation that the entity will undertake activities to change the functionality of the drug formula during the license period. Because the intellectual property has significant standalone functionality, any other activities the entity might undertake (for example, promotional activities like advertising or activities to develop other drug products) would not significantly affect the utility of the licensed intellectual property. Consequently, the nature of the entity’s promise in transferring the license is to provide a right to use the entity’s functional intellectual property, and it accounts for the license as a performance obligation satisfied at a point in time. The entity recognizes revenue for the license performance obligation in accordance with paragraphs 606-10-55-58B through 55-58C.

55-374 In its assessment of the nature of the license, the entity does not consider the manufacturing service because it is an additional promised service in the contract. The entity applies paragraphs 606-10-25-23 through 25-30 to determine whether the manufacturing service is a performance obligation satisfied at a point in time or over time.

Example 57 — Franchise Rights

55-375 An entity enters into a contract with a customer and promises to grant a franchise license that provides the customer with the right to use the entity’s trade name and sell the entity’s products for 10 years. In addition to the license, the entity also promises to provide the equipment necessary to operate a franchise store. In exchange for granting the license, the entity receives a fixed fee of $1 million, as well as a sales-based royalty of 5 percent of the customer’s sales for the term of the license. The fixed consideration for the equipment is $150,000 payable when the equipment is delivered.

Identifying Performance Obligations

55-376 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity observes that the entity, as a franchisor, has developed a customary business practice to undertake activities such as analyzing the consumers’ changing preferences and implementing product improvements, pricing strategies, marketing campaigns, and operational efficiencies to support the franchise name. However, the entity concludes that these activities do not directly transfer goods or services to the customer.

55-377 The entity determines that it has two promises to transfer goods or services: a promise to grant a license and a promise to transfer equipment. In addition, the entity concludes that the promise to grant the license and the promise to transfer the equipment are each distinct. This is because the customer can benefit from each good or service (that is, the license and the equipment) on its own or together with other resources that are readily available (see paragraph 606-10-25-19(a)). The customer can benefit from the license together with the equipment that is delivered before the opening of the franchise, and the equipment can be used in the franchise or sold for an amount other than scrap value. The entity also determines that the promises to grant the franchise license and to transfer the equipment are separately identifiable in accordance with the criterion in paragraph 606-10-25-19(b). The entity concludes that the license and the equipment are not inputs to a combined item (that is, they are not fulfilling what is, in effect, a single promise to the customer). In reaching this conclusion, the entity considers that it is not providing a significant service of integrating the license and the equipment into a combined item (that is, the licensed intellectual property is not a component of, and does not significantly modify, the equipment). Additionally, the license and the equipment are not highly interdependent or highly interrelated because the entity would be able to fulfill each promise (that is, to license the franchise or to transfer the equipment) independently of the other. Consequently, the entity has two performance obligations:

The franchise license
The equipment.

Allocating the Transaction Price

55-378 The entity determines that the transaction price includes fixed consideration of $1,150,000 and variable consideration (5 percent of the customer’s sales from the franchise store). The standalone selling price of the equipment is $150,000 and the entity regularly licenses franchises in exchange for 5 percent of customer sales and a similar upfront fee.

55-379 The entity applies paragraph 606-10-32-40 to determine whether the variable consideration should be allocated entirely to the performance obligation to transfer the franchise license. The entity concludes that the variable consideration (that is, the sales-based royalty) should be allocated entirely to the franchise license because the variable consideration relates entirely to the entity’s promise to grant the franchise license. In addition, the entity observes that allocating $150,000 to the equipment and allocating the sales-based royalty (as well as the additional $1 million in fixed consideration) to the franchise license would be consistent with an allocation based on the entity’s relative standalone selling prices in similar contracts. Consequently, the entity concludes that the variable consideration (that is, the sales-based royalty) should be allocated entirely to the performance obligation to grant the franchise license.

Licensing

55-380 The entity assesses the nature of the entity’s promise to grant the franchise license. The entity concludes that the nature of its promise is to provide a right to access the entity’s symbolic intellectual property. The trade name and logo have limited standalone functionality; the utility of the products developed by the entity is derived largely from the products’ association with the franchise brand. Substantially all of the utility inherent in the trade name, logo, and product rights granted under the license stems from the entity’s past and ongoing activities of establishing, building, and maintaining the franchise brand. The utility of the license is its association with the franchise brand and the related demand for its products.

Subparagraph superseded by Accounting Standards Update No. 2016-10.
Subparagraph superseded by Accounting Standards Update No. 2016-10.
Subparagraph superseded by Accounting Standards Update No. 2016-10.

55-381 The entity is granting a license to symbolic intellectual property. Consequently, the license provides the customer with a right to access the entity’s intellectual property and the entity’s performance obligation to transfer the license is satisfied over time in accordance with paragraph 606-10-55-58A. The entity recognizes the fixed consideration allocable to the license performance obligation in accordance with paragraph 606-10-55-58A and paragraph 606-10-55-58C. This includes applying paragraphs 606-10-25-31 through 25-37 to identify the method that best depicts the entity’s performance in satisfying the license (see paragraph 606-10-55-382).

55-382 Because the consideration that is in the form of a sales-based royalty relates specifically to the franchise license (see paragraph 606-10-55-379), the entity applies paragraph 606-10-55-65 in recognizing that consideration as revenue. Consequently, the entity recognizes revenue from the sales-based royalty as and when the sales occur. The entity concludes that recognizing revenue resulting from the sales-based royalty when the customer’s subsequent sales occur is consistent with the guidance in paragraph 606-10-55-65(b). That is, the entity concludes that ratable recognition of the fixed $1 million franchise fee plus recognition of the periodic royalty fees as the customer’s subsequent sales occur reasonably depict the entity’s performance toward complete satisfaction of the franchise license performance obligation to which the sales-based royalty has been allocated.

Example 61A — Right to Use Intellectual Property

55-399A An entity, a television production company, licenses all of the existing episodes of a television show (which consists of the first four seasons) to a customer. The show is presently in its fifth season, and the television production company is producing episodes for that fifth season at the time the contract is entered into, as well as promoting the show to attract further viewership. The Season 5 episodes in production are still subject to change before airing.

Case B — Contract Includes Two Promises

55-399F Consistent with Case A, the contract provides the customer with the right to broadcast the existing episodes, in sequential order, over a period of two years. The contract also grants the customer the right to broadcast the episodes being produced for Season 5 once all of those episodes are completed.

55-399G The entity assesses the goods and services promised to the customer. The entity concludes that there are two promised goods or services in the contract:

The license to the existing episodes (see paragraph 606-10-55-399C)
The license to the episodes comprising Season 5, when all of those episodes are completed.

55-399H The entity then evaluates whether the license to the existing content is distinct from the license to the Season 5 episodes when they are completed. The entity concludes that the two licenses are distinct from each other and, therefore, separate performance obligations. This conclusion is based on the following analysis:

Each license is capable of being distinct because the customer can benefit from its right to air the existing completed episodes on their own and can benefit from the right to air the episodes comprising Season 5, when they are all completed, on their own and together with the right to air the existing completed content.
Each of the two promises to transfer a license in the contract also is separately identifiable; they do not, together, constitute a single overall promise to the customer. The existing episodes do not modify or customize the Season 5 episodes in production, and the existing episodes do not, together with the pending Season 5 episodes, result in a combined functionality or changed content. The right to air the existing content and the right to air the Season 5 content, when available, are not highly interdependent or highly interrelated because the entity’s ability to fulfill its promise to transfer either license is unaffected by its promise to transfer the other. In addition, whether the customer or another licensee had rights to air the future episodes would not be expected to significantly affect the customer’s license to air the existing, completed episodes (for example, viewers’ desire to watch existing episodes from Seasons 1–4 on the customer’s network generally would not be significantly affected by whether the customer, or another network, had the right to broadcast the episodes that will comprise Season 5).

55-399I The entity assesses the nature of the two separate performance obligations (that is, the license to the existing, completed episodes of the series and the license to episodes that will comprise Season 5 when completed). To determine whether the licenses provide the customer with rights to use the entity’s intellectual property or rights to access the entity’s intellectual property, the entity considers the following:

The licensed intellectual property (that is, the completed episodes in Seasons 1–4 and the episodes in Season 5, when completed) has significant standalone functionality separate from the entity’s ongoing business activities, such as in producing additional intellectual property (for example, future seasons) or in promoting the show, and completed episodes can be aired without the entity’s further involvement.
There is no expectation that the entity will substantively change any of the content once it is made available to the customer for broadcast (that is, the criteria in paragraph 606-10-55-62 are not met).
The activities expected to be undertaken by the entity to produce Season 5 and transfer the right to air those episodes constitute an additional promised good (license) in the contract and, therefore, do not affect the nature of the entity’s promise in granting the license to Seasons 1–4.

55-399J Therefore, the entity concludes that both the license to the existing episodes in the series and the license to the episodes that will comprise Season 5 provide the customer with the right to use its functional intellectual property as it exists at the point in time the license is granted. As a result, the entity recognizes the portion of the transaction price allocated to each license at a point in time in accordance with paragraphs 606-10-55-58B through 55-58C. That is, the entity recognizes the revenue attributable to each license on the date that the customer is first permitted to first air the content included in each performance obligation. That date is the beginning of the period during which the customer is able to use and benefit from its right to use the licensed intellectual property.

The application of the revenue standard to arrangements that include a license of IP may be challenging. In particular, the determination of whether rights promised to a customer in a licensing arrangement should be combined or separated is often complex and may require significant judgment. In the Background Information and Basis for Conclusions of ASU 2016-10, the FASB acknowledged such challenges as follows:

BC41 The Board previously observed that all contracts require an assessment of the promised goods and services in the contract and the criteria for identifying performance obligations (see paragraphs 606-10-25-14 through 25-22). This includes an assessment of whether a customer can benefit from the license on its own or together with other resources that are readily available to the customer (see paragraph 606-10-25-19(a)) and whether the entity’s promise to transfer the license is separately identifiable from other goods or services in the contract (see paragraph 606-10-25-19(b)). The Boards observed that this assessment might sometimes be challenging.

BC42 Identifying separate deliverables (or elements) in licensing arrangements often is challenging under previous GAAP (for example, in many software or biotechnology arrangements), and it was never the Board’s intention to eliminate judgment in this area. While stakeholders in industries that engage in significant licensing activities have questioned this, the Board concluded that no additional guidance on identifying performance obligations specifically tailored to entities that license intellectual property is necessary. The Board expects that the improvements in this Update will assist all entities in applying the general identifying performance obligations guidance in paragraphs 606-10-25-14 through 25-22, including entities that license intellectual property. [Emphasis added]

The Background Information and Basis for Conclusions of ASU 2014-09 and that of ASU 2016-10 both emphasize the need for an entity to use judgment when assessing whether promised goods or services are distinct within the context of the contract. Paragraphs BC27 and BC28 of ASU 2016-10 state the following:

BC27 The criterion in paragraph 606-10-25-19(b) as well as the principle and the factors in paragraph 606-10-25-21 were developed with the understanding that application will require the exercise of judgment. This was in direct response to stakeholders’ feedback received during the development of Topic 606. Stakeholders expressed concerns that the proposed separation guidance in the 2010 and 2011 proposed Updates did not appropriately address the wide variety of revenue arrangements that existed in practice across all industries. Stakeholders asserted that the separation guidance might have resulted in the identification of performance obligations that do not appropriately reflect the arrangement with a customer.

BC28 Stakeholders requested, and the Board decided to establish, guidance that permits judgment in this area. The Board observed that identifying separate deliverables or separate elements under existing revenue guidance also is challenging and judgmental, especially in particular industries. Although judgment is required, the Board has observed different interpretations of the criterion in paragraph 606-10-25-19(b) and the guidance in paragraph 606-10-25-21. For those reasons, the Board decided to clarify that guidance by better articulating the separately identifiable principle. Although the language describing the principle has been expanded, the amendments merely better describe the Board’s intentions and are not a change to the underlying principle. Even with the improvements in this Update, the Board recognizes that judgment will be needed to determine whether promised goods or services are distinct. [Emphasis added]

ASU 2016-10’s Background Information and Basis for Conclusions expands on the separately identifiable principle described in ASC 606-10-25-21 and the FASB’s intent regarding application of that principle as follows:

Focusing on the principle; inputs to a combined output — Paragraph BC29 notes that the separately identifiable principle requires an entity to consider “whether the multiple promised goods or services in the contract are outputs or, instead, are inputs to a combined item (or items).” The paragraph goes on to explain that the “combined item . . . is greater than (or substantively different from) the sum of those promised (component) goods and services.” In addition, paragraph BC31 explains that the factors listed in ASC 606-10-25-21 are intended to support the principle and should not be viewed as criteria to be evaluated independently. If multiple promised goods or services represent inputs rather than individual outputs, such goods or services would not be separately identifiable.

Level of integration, interrelation, or interdependence — Paragraph BC32 of ASU 2016-10 states, in part:

The separately identifiable principle is intended to consider the level of integration, interrelation, or interdependence among promises to transfer goods or services. That is, the separately identifiable principle is intended to evaluate when an entity’s performance in transferring a bundle of goods or services in a contract is, in substance, fulfilling a single promise to a customer. Therefore, the entity should evaluate whether two or more promised goods or services (for example, a delivered item and an undelivered item) each significantly affect the other (and, therefore, are highly interdependent or highly interrelated) in the contract. The entity should not merely evaluate whether one item, by its nature, depends on the other (for example, an undelivered item that would never be obtained by a customer absent the presence of the delivered item in the contract or the customer having obtained that item in a different contract).

The greater the level of integration, interrelation, or interdependence, the less likely it is that the promised goods or services are separately identifiable (i.e., the more likely it is that those goods or services should be combined into a single performance obligation). In a discussion not included in ASC 606 about how an entity should evaluate the level of integration, interrelation, or interdependence of multiple promised goods or services, paragraph BC116K of IFRS 15 states that “rather than considering whether one item, by its nature, depends on the other (ie whether two items have a functional relationship), an entity evaluates whether there is a transformative relationship between the two items in the process of fulfilling the contract.”
Diminution of utility — As indicated below, paragraph BC33(b) of ASU 2016-10 discusses how the utility of a license may depend on updates to the license and therefore should be considered in the evaluation of whether multiple promised goods or services are separately identifiable:

[I]n Example 10, Case C [ASC 606-10-55-140D through 55-140F], or in Example 55 [ASC 606-10-55-364 through 55-366], the entity’s ability to transfer the initial license is not affected by its promise to transfer the updates or vice versa, but the provision (or not) of the updates will significantly affect the utility of the licensed intellectual property to the customer such that the license and the updates are not separately identifiable. They are, in effect, inputs to the combined solution for which the customer contracted. The “capable of being distinct” criterion also considers the utility of the promised good or service, but merely establishes the baseline level of economic substance a good or service must have to be “capable of being distinct.” Therefore, utility also is relevant in evaluating whether two or more promises in a contract are separately identifiable because even if two or more goods or services are capable of being distinct because the customer can derive some economic benefit from each one, the customer’s ability to derive its intended benefit from the contract may depend on the entity transferring each of those goods or services. [Emphasis added]

When the utility of one promised good or service significantly depends on another promised good or service, it is less likely that those goods or services are separately identifiable. Specifically, an entity should consider (1) how quickly the utility of the initial license diminishes and, therefore, (2) how quickly the customer needs to incorporate any updates or upgrades to the licensed IP to continue to benefit and derive utility from the originally licensed IP.

12.3.1 Portfolio of Licenses to Patents

Some industries have a practice of selling a portfolio of licenses to patented IP (e.g., patented technology or know-how). Because the patented IP represents functional IP (see Section 12.4.1), the related licenses grant an entity’s customer a right to use the patented IP. In a typical arrangement to sell such a portfolio of licenses, the rights conveyed to the customer extend not only to all currently available patents (the “current patents”) but also to any patents that the entity develops later in the license term (the “future patents”). The effect of this type of arrangement is to expand the rights that are initially granted to the customer (i.e., the current patents) by providing the customer with the rights to future patents that are developed over the term of the arrangement. The current patents and future patents are capable of being distinct in accordance with ASC 606-10-25-19(a) because the customer is able to benefit from the current patents or future patents either on their own or together with readily available resources.

An entity that has entered into an arrangement with a customer to license a portfolio of patents should consider the “separately identifiable” principle in ASC 606-10-25-19(b) and related factors in ASC 606-10-25-21, including (1) whether the current patents and future patents are inputs to a combined output, (2) the level of integration, interrelation, or interdependence between the current patents and future patents, and (3) the diminution of the utility of the current patents without a right to the future patents. For example, the entity should consider (1) how quickly the utility of the current patents diminishes once new patents are issued and (2) how quickly the customer needs to incorporate any updates and upgrades to the current patents to continue benefiting and deriving utility from the current patents. If the entity is required to immediately update the portfolio for any new patents once issued, that may suggest that the utility of the current patents is significantly diminished without the new patents.

The entity should consider its facts and circumstances when it assesses the separately identifiable principle to determine whether the initially delivered rights (i.e., the current patents) are distinct within the context of the contract from the ongoing rights that it is contractually required to deliver over the term of the agreement (i.e., the future patents).

12.3.2 Determining Whether Contractual Provisions Represent Attributes of a License or Additional Rights

A contract with a customer may contain provisions that limit the customer’s use of a license of IP to a specific period, geographic region, or use. For example, an entity may license media content to a customer that can be (1) used for three years, (2) made available only to consumers in North America, and (3) broadcasted only on a specific network. Often, such restrictions will be attributes of the license. That is, the restrictions will define the rights the customer has under the license, and all of those rights will be transferred to the customer either at a point in time (if the license is a right to use IP) or over time (if the license is a right to access IP). However, some restrictions, or changes in restrictions over time, will require an entity to transfer additional rights to a customer. Specifically, the amendments in ASU 2016-10 clarify that (1) certain contractual provisions indicate that an entity has promised to transfer additional rights (i.e., an additional license) to a customer and (2) promises to transfer additional rights should be accounted for as separate performance obligations.

ASC 606-10

55-64 Contractual provisions that explicitly or implicitly require an entity to transfer control of additional goods or services to a customer (for example, by requiring the entity to transfer control of additional rights to use or rights to access intellectual property that the customer does not already control) should be distinguished from contractual provisions that explicitly or implicitly define the attributes of a single promised license (for example, restrictions of time, geographical region, or use). Attributes of a promised license define the scope of a customer’s right to use or right to access the entity’s intellectual property and, therefore, do not define whether the entity satisfies its performance obligation at a point in time or over time and do not create an obligation for the entity to transfer any additional rights to use or access its intellectual property.

Subparagraph superseded by Accounting Standards Update No. 2016-10.
Subparagraph superseded by Accounting Standards Update No. 2016-10.

55-64A Guarantees provided by the entity that it has a valid patent to intellectual property and that it will defend that patent from unauthorized use do not affect whether a license provides a right to access the entity’s intellectual property or a right to use the entity’s intellectual property. Similarly, a promise to defend a patent right is not a promised good or service because it provides assurance to the customer that the license transferred meets the specifications of the license promised in the contract.

The determination of whether contractual provisions related to a license of IP represent an additional promise may require significant judgment. Contractual provisions (restrictions) that define the scope of a license of IP that has already been transferred to a customer would generally not be accounted for as a separate performance obligation. For example, a restriction that limits the use of a license to a five-year period would be an attribute of the single license. However, contractual provisions that define additional rights that will be transferred at a future date would generally be accounted for as a separate performance obligation, as illustrated in the example below.

Example 12-3

An entity transfers to a customer a two-year license of IP that can be used only in Jurisdiction A during year 1 but can be used in both Jurisdiction A and Jurisdiction B during year 2 in exchange for a fixed fee of $100,000. The entity concludes that the license is a right to access IP that will be transferred to the customer over time. In this example, the customer does not obtain control of the license in Jurisdiction B until year 2. That is, in year 2, the entity must transfer additional rights that entitle the customer to use the license in Jurisdiction B. Although the entity transfers the license to use the IP in Jurisdiction A at the beginning of year 1, the entity must still fulfill a second promise to deliver the license to use the IP in Jurisdiction B in year 2. Further, although the license of IP obtained by the customer in year 1 may be the same license of IP that will be used in year 2 (i.e., the customer currently controls the right to use or access the IP), the customer is precluded from using and benefiting from that license in Jurisdiction B until year 2. The obligation to transfer additional rights to the customer at the beginning of year 2 should be identified as an additional performance obligation under the contract with the customer.

In allocating the transaction price of $100,000 to the two performance obligations, the entity determines that the stand-alone selling prices of delivering the license to Jurisdiction A for two years and Jurisdiction B for one year are $60,000 and $40,000, respectively. Under these circumstances, the entity would then recognize revenue of $30,000 over year 1 and $70,000 over year 2, which is calculated as follows:

Year 1 (Jurisdiction A) — ($60,000 ÷ 2) × 1 year of service = $30,000.
Year 2 (Jurisdiction A) — ($60,000 ÷ 2) × 1 year of service = $30,000.
Year 2 (Jurisdiction B) — $40,000 × 1 year of service = $40,000.

The example above assumes that the license constitutes a right to access IP that will be transferred to the customer over time. The determination of whether a license is a right to access IP for which revenue is recognized over time or a right to use IP for which revenue is recognized at a point in time is discussed in Section 12.4.

Paragraph BC45 of ASU 2016-10 indicates that a substantive break between the periods for which an entity’s customer has the right to use IP might create multiple licenses since the substantive break “might suggest that the customer’s rights have been ‘revoked’ for that period of time and that the entity has made an additional promise to transfer rights to use that same [IP] again at the later date.” Accordingly, an entity should use judgment to determine whether a break is “substantive” and therefore creates an additional license of IP (i.e., a separate performance obligation).

The Codification examples below illustrate how an entity would apply the guidance on determining whether contractual provisions represent attributes of a license or additional promises to a customer.

ASC 606-10

Example 59 — Right to Use Intellectual Property

Case A — Initial License

55-389 An entity, a music record label, licenses to a customer a recording of a classical symphony by a noted orchestra. The customer, a consumer products company, has the right to use the recorded symphony in all commercials, including television, radio, and online advertisements for two years in Country A starting on January 1, 20X1. In exchange for providing the license, the entity receives fixed consideration of $10,000 per month. The contract does not include any other goods or services to be provided by the entity. The contract is noncancellable.

55-390 The entity assesses the goods and services promised to the customer to determine which goods and services are distinct in accordance with paragraph 606-10-25-19. The entity concludes that its only performance obligation is to grant the license. The term of the license (two years), the geographical scope of the license (that is, the customer’s right to use the symphony only in Country A), and the defined permitted uses for the recording (that is, use in commercials) are all attributes of the promised license in this contract.

55-391 In determining that the promised license provides the customer with a right to use its intellectual property as it exists at the point in time at which the license is granted, the entity considers the following:

The classical symphony recording has significant standalone functionality because the recording can be played in its present, completed form without the entity’s further involvement. The customer can derive substantial benefit from that functionality regardless of the entity’s further activities or actions. Therefore, the nature of the licensed intellectual property is functional.
The contract does not require, and the customer does not reasonably expect, that the entity will undertake activities to change the licensed recording.

Therefore, the criteria in paragraph 606-10-55-62 are not met.

55-392 In accordance with paragraph 606-10-55-58B, the promised license, which provides the customer with a right to use the entity’s intellectual property, is a performance obligation satisfied at a point in time. The entity recognizes revenue from the satisfaction of that performance obligation in accordance with paragraphs 606-10-55-58B through 55-58C. Additionally, because of the length of time between the entity’s performance (at the beginning of the period) and the customer’s monthly payments over two years (which are noncancellable), the entity considers the guidance in paragraphs 606-10-32-15 through 32-20 to determine whether a significant financing component exists.

Example 61A — Right to Use Intellectual Property

Case A — License Is the Only Promise in the Contract

55-399B The customer obtains the right to broadcast the existing episodes, in sequential order, for a period of two years. The show has been successful through the first four seasons, and the customer is both aware that Season 5 already is in production and aware of the entity’s continued promotion of the show. The customer will make fixed monthly payments of an equal amount throughout the two-year license period.

55-399C The entity assesses the goods and services promised to the customer. The entity’s activities to produce Season 5 and its continued promotion of the show do not transfer a promised good or service to the customer. Therefore, the entity concludes that there are no other promised goods or services in the contract other than the license to broadcast the existing episodes in the television series. The contractual requirement to broadcast the episodes in sequential order is an attribute of the license (that is, a restriction on how the customer may use the license); therefore, the only performance obligation in this contract is the single license to the completed Seasons 1–4.

55-399D To determine whether the promised license provides the customer with a right to use its intellectual property or a right to access its intellectual property, the entity evaluates the intellectual property that is the subject of the license. The existing episodes have substantial standalone functionality at the point in time they are transferred to the customer because the episodes can be aired, in the form transferred, without any further participation by the entity. Therefore, the customer can derive substantial benefit from the completed episodes, which have significant utility to the customer without any further activities of the entity. The entity further observes that the existing episodes are complete and not subject to change. Thus, there is no expectation that the functionality of the intellectual property to which the customer has rights will change (that is, the criteria in paragraph 606-10-55-62 are not met). Therefore, the entity concludes that the license provides the customer with a right to use its functional intellectual property.

55-399E Consequently, in accordance with paragraph 606-10-55-58B, the license is a performance obligation satisfied at a point in time. In accordance with paragraphs 606-10-55-58B through 55-58C, the entity recognizes revenue for the license on the date that the customer is first permitted to air the licensed content, assuming the content is made available to the customer on or before that date. The date the customer is first permitted to air the licensed content is the beginning of the period during which the customer is able to use and benefit from its right to use the intellectual property. Because of the length of time between the entity’s performance (at the beginning of the period) and the customer’s annual payments over two years (which are noncancellable), the entity considers the guidance in paragraphs 606-10-32-15 through 32-20 to determine whether a significant financing component exists.

Example 61B — Distinguishing Multiple Licenses From Attributes of a Single License

55-399K On December 15, 20X0, an entity enters into a contract with a customer that permits the customer to embed the entity’s functional intellectual property in two classes of the customer’s consumer products (Class 1 and Class 2) for five years beginning on January 1, 20X1. During the first year of the license period, the customer is permitted to embed the entity’s intellectual property only in Class 1. Beginning in Year 2 (that is, beginning on January 1, 20X2), the customer is permitted to embed the entity’s intellectual property in Class 2. There is no expectation that the entity will undertake activities to change the functionality of the intellectual property during the license period. There are no other promised goods or services in the contract. The entity provides (or otherwise makes available — for example, makes available for download) a copy of the intellectual property to the customer on December 20, 20X0.

55-399L In identifying the goods and services promised to the customer in the contract (in accordance with guidance in paragraphs 606-10-25-14 through 25-18), the entity considers whether the contract grants the customer a single promise, for which an attribute of the promised license is that during Year 1 of the contract the customer is restricted from embedding the intellectual property in the Class 2 consumer products), or two promises (that is, a license for a right to embed the entity’s intellectual property in Class 1 for a five-year period beginning on January 1, 20X1, and a right to embed the entity’s intellectual property in Class 2 for a four-year period beginning on January 1, 20X2).

55-399M In making this assessment, the entity determines that the provision in the contract stipulating that the right for the customer to embed the entity’s intellectual property in Class 2 only commences one year after the right for the customer to embed the entity’s intellectual property in Class 1 means that after the customer can begin to use and benefit from its right to embed the entity’s intellectual property in Class 1 on January 1, 20X1, the entity must still fulfill a second promise to transfer an additional right to use the licensed intellectual property (that is, the entity must still fulfill its promise to grant the customer the right to embed the entity’s intellectual property in Class 2). The entity does not transfer control of the right to embed the entity’s intellectual property in Class 2 before the customer can begin to use and benefit from that right on January 1, 20X2.

55-399N The entity then concludes that the first promise (the right to embed the entity’s intellectual property in Class 1) and the second promise (the right to embed the entity’s intellectual property in Class 2) are distinct from each other. The customer can benefit from each right on its own and independently of the other. Therefore, each right is capable of being distinct in accordance with paragraph 606-10-25-19(a)). In addition, the entity concludes that the promise to transfer each license is separately identifiable (that is, each right meets the criterion in paragraph 606-10-25-19(b)) on the basis of an evaluation of the principle and the factors in paragraph 606-10-25-21. The entity concludes that it is not providing any integration service with respect to the two rights (that is, the two rights are not inputs to a combined output with functionality that is different from the functionality provided by the licenses independently), neither right significantly modifies or customizes the other, and the entity can fulfill its promise to transfer each right to the customer independently of the other (that is, the entity could transfer either right to the customer without transferring the other). In addition, neither the Class 1 license nor the Class 2 license is integral to the customer’s ability to use or benefit from the other.

55-399O Because each right is distinct, they constitute separate performance obligations. On the basis of the nature of the licensed intellectual property and the fact that there is no expectation that the entity will undertake activities to change the functionality of the intellectual property during the license period, each promise to transfer one of the two licenses in this contract provides the customer with a right to use the entity’s intellectual property and the entity’s promise to transfer each license is, therefore, satisfied at a point in time. The entity determines at what point in time to recognize the revenue allocable to each performance obligation in accordance with paragraphs 606-10-55-58B through 55-58C. Because a customer does not control a license until it can begin to use and benefit from the rights conveyed, the entity recognizes revenue allocated to the Class 1 license no earlier than January 1, 20X1, and the revenue on the Class 2 license no earlier than January 1, 20X2.

12.3.3 Distinguishing an Option to Acquire Additional Rights From Provisions Giving Rise to Variable Consideration in the Form of a Sales- or Usage-Based Royalty

As discussed in ASC 606-10-55-64, contractual provisions in a licensing transaction may allow an entity’s customer to obtain additional benefits or rights after the initial transfer of the license. An entity may need to use significant judgment to differentiate between contractual terms that allow a customer to obtain additional rights that the customer does not already control (thereby creating additional performance obligations) and contractual terms that allow for additional usage of IP already controlled by the customer (which would not create additional performance obligations but may entitle the entity to additional variable consideration in the form of a sales- or usage-based royalty). The entity will need to evaluate any option to acquire additional rights to use or access the IP to determine whether the option gives rise to a material right.

Paragraph BC46 of ASU 2016-10 states, in part, that “judgment often is required in distinguishing a single promised license with multiple attributes from a license that contains multiple promises to the customer in the contract.” The determination of whether contractual provisions that allow the customer to obtain additional benefits or rights constitute optional purchases or variable consideration related to rights already controlled by the customer could affect the timing of revenue recognition if the optional additional rights give rise to a material right.

When options to acquire additional rights not already controlled by the customer are priced at their stand-alone selling prices, the timing and amount of revenue recognized will most likely be the same as if the contractual rights gave rise to variable consideration in the form of a sales- or usage-based royalty. However, the differentiation may still be important since consideration in the form of a sales- or usage-based royalty is a form of variable consideration to which the disclosure requirements in ASC 606-10-50-15 might apply (e.g., if the nature of the license is a right-to-access license of IP that is transferred to the customer over time).

An entity will need to use judgment on the basis of the specific facts and circumstances of the arrangement to determine whether (1) the contract includes an option to acquire additional rights to use or access IP or (2) the contractual provisions give rise to variable consideration in the form of a sales- or usage-based royalty.

The following factors may indicate that the contractual provisions (1) give the customer an option to acquire additional rights to use or access IP or (2) represent an obligation to transfer additional rights to the customer that constitutes a separate performance obligation:

The customer’s right to use or access the initial IP changes when the additional rights are obtained (e.g., the customer can embed the IP within a new or different product or can use the IP in a different geographic area).
The customer obtains new or expanded functionality as a result of the additional rights obtained.
The additional rights obtained for a fee continue for the duration of the license agreement rather than expiring upon usage, and the additional usage during that period does not result in additional fees. That is, the additional rights are acquired for an additional initial fee, but the additional rights are not wholly consumed once the rights are acquired (e.g., the customer expands the use of functional IP from 100 users to 200 users for the duration of the license term) and no ongoing usage fee is payable.
The license is transferred to a reseller (requiring the reseller to pay a fee per copy, license, or end user upon making a purchase or sale), and the reseller is not using the functionality provided by the license itself but is transferring the rights to use the IP to end users. Because the reseller is simply purchasing and reselling the software product, the software product is more akin to any other tangible product that is purchased for resale. In these situations, the transaction between the vendor and the reseller is one in which the vendor is selling and the reseller is purchasing incremental software rights that the reseller does not already control each time the reseller pays a fee to transfer the vendor’s software to an end user.

The following factors may indicate that the contractual provisions give the customer a right to additional usage of a single license, which would give rise to variable consideration:

The customer controls the rights to use or access the IP but is required to pay additional consideration based on how often the IP is used (e.g., consideration is payable each time the IP performs a task, or each time the IP is integrated into a device and contributes to the device’s functionality).
The additional usage of the IP does not provide sustained additional benefits without additional fees. For example, a customer may have to pay a fee each time it uses software to perform a task rather than a fixed fee that allows the customer to continually use the software to perform tasks.

Sometimes, specific performance by the licensor will be required before additional rights are granted or additional usage of a single license is allowed. For example, a software licensor may need to provide the licensee with a software key each time software is embedded in a device. The fact that the licensor is required to provide a software key for each license does not necessarily mean that a new right is transferred to the licensee with each key (i.e., specific actions required by the licensor are not in and of themselves determinative of whether additional rights have been transferred to the licensee). Rather, an entity should evaluate all facts and circumstances when determining whether contractual provisions (1) give a customer the right to acquire additional rights to use or access IP that it does not already control in exchange for additional consideration or (2) give rise to variable consideration in the form of a sales- or usage-based royalty.

12.3.3.1 Accounting for a Customer’s Option to Purchase or Use Additional Copies of Software

A software license arrangement accounted for as a right-to-use license (i.e., a license for which revenue is recognized at a point in time) may (1) transfer a license and require the customer to make a fixed payment at inception and (2) include an option for the customer to obtain additional rights that allow the software to be used by additional users for incremental fees per user.7 Alternatively (or in addition), a right-to-use license arrangement may provide for “additional usage” of a single license in exchange for incremental fees per use.

As discussed in Section 12.3.3, an entity in a right-to-use license arrangement will need to use judgment to determine whether the nature of the arrangement is to provide the customer with an option to obtain additional rights (e.g., for additional users) or to require payment of incremental fees for additional usage of rights already controlled by the customer.

An arrangement in which an entity provides an option to the customer to obtain rights for additional users typically represents promises to provide additional licenses (i.e., additional performance obligations) for an incremental fee. Those optional additional purchases (i.e., options that would require an entity to transfer additional rights to the customer) would not initially be included in the contract; however, they should be evaluated for favorable terms that may give rise to a material right. For further discussion, see Section 12.3.3.2.

In some cases, additional copies of a software license could represent additional usage of a single license as opposed to additional users. As discussed in Section 12.3.3, an entity will need to use judgment on the basis of the specific facts and circumstances of the arrangement. For example, the ability to use additional copies of a license for an incremental fee in certain reseller arrangements could represent additional usage as opposed to optional purchases of additional rights (see Example 12-5).

An arrangement in which an entity provides additional usage of a single license (i.e., usage of rights already controlled by the customer) could include additional consideration as part of the transaction price for a single license. Because the additional potential consideration is based on usage of a single license, it would be subject to the sales- or usage-based royalty exception (under the assumption that the license is predominant if there are multiple promises) and be recognized no earlier than when the subsequent usage occurs.

Example 12-4

Licensor sells Customer Y 1,000 licenses of Product A for $50,000. Each license allows Y one seat to use Product A for the duration of the contract term. Customer Y can purchase additional licenses of Product A for $30 per license that will allow Y to use Product A in an additional seat (i.e., add users). Licensor provides separate activation keys for each license. Customer Y can use additional licenses purchased for the remaining contract term.

The option to acquire additional licenses would be viewed as an option that gives the customer additional rights (and, therefore, as an additional performance obligation if the option gives rise to a material right). This is because if Y exercises the option to acquire additional licenses to Product A, Licensor would be required to transfer additional rights for additional users that Y does not already control. Therefore, Licensor should evaluate the option to determine whether it gives rise to a material right.

Example 12-5

Licensor provides OEM with a master copy of software that OEM can use to reproduce copies of the license for integration only into Product A, which contributes to Product A’s functionality. OEM pays Licensor a fee of $50 for each use (i.e., integration into Product A) up to 1,000 uses and $30 for each use above 1,000 licenses.

The customer controls the rights provided by the software license and has committed to pay a fee that varies depending on the use of the license (rather than on the basis of additional rights acquired, which would be a separate performance obligation). The rights provided by the software give rise to variable consideration to which the sales- or usage-based royalty exception in ASC 606-10-55-65 through 55-65B applies.

Example 12-6

Assume the same facts as in the previous example, except that the contract gives OEM the option to obtain the right to integrate the software into Product B (and contribute to Product B’s functionality) for an additional $10,000. If the right is exercised, OEM will also pay a fee of $40 for each use of the software in Product B (the price of the software included in Product A remains unchanged). OEM will use the same master copy to replicate the software as that provided in the previous example, which requires no action by Licensor.

The option to acquire the rights to include the software in Product B allows OEM to acquire additional rights to use the IP (and is therefore an additional performance obligation if the option gives rise to a material right). That is, the OEM does not have the right to integrate the software into Product B unless it exercises the option, at which point Licensor will transfer additional rights to OEM that OEM does not already control. Therefore, Licensor should evaluate the option to determine whether it gives rise to a material right. The additional consideration that is paid to Licensor for each use of the software in Product B is variable consideration to which the sales- or usage-based royalty exception in ASC 606-10-55-65 through 55-65B applies.

Example 12-7

Licensor enters into a five-year contract to sell an unknown quantity of software licenses to Reseller. Each license gives Reseller the right to resell the individual software licenses to end users. Reseller does not have any other rights related to the software. Reseller pays $50,000 for the first 2,500 software licenses that can be downloaded on demand. Further, Reseller pays $15 for each additional software license sold above the initial 2,500 licenses during the five-year contract term.

In this example, Reseller obtains the right to resell Licensor’s software but does not obtain end-user rights associated with the software. Any additional consideration above the initial $50,000 payment is in exchange for Licensor’s granting additional software licenses that Reseller will resell to end users. That is, Licensor transfers additional rights to Reseller with each additional license.

In addition, because the price per license sold after the initial 2,500 licenses ($15 per license) is less than the price per license for the first 2,500 licenses ($20 per license), Licensor should consider whether there is a material right related to the right to purchase additional software licenses.

The above issue is addressed in Q&A 58 (compiled from previously issued TRG Agenda Papers 45 and 49) of the FASB staff’s Revenue Recognition Implementation Q&As (the “Implementation Q&As”). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

12.3.3.2 Material Right Assessment

If an entity in a right-to-use license arrangement determines that the arrangement provides for an option to purchase additional rights such as users (i.e., an option to acquire additional licenses, which would constitute additional performance obligations), the entity should perform an evaluation in accordance with ASC 606-10-55-42 to determine whether the customer’s option to add licenses at a later date on the basis of a per-license fee represents a material right. If the option represents a material right, the entity should allocate a portion of the transaction price for the initial license rights to the material right.

If the option does not represent a material right, the entity would not account for the additional license rights until the subsequent purchases for additional licenses occur. This accounting outcome (i.e., no identification of a material right) results in a recognition pattern similar to that of an arrangement that is determined to allow for additional usage. When the arrangement is determined to provide for additional usage, consideration for that incremental usage is deemed to be variable consideration for the license already transferred. Therefore, since the arrangement includes a license of IP, the sales- or usage-based royalty guidance in ASC 606-10-55-65 would apply (under the assumption that, as described in ASC 606-10-55-65A, the license is “the predominant item to which the royalty relates” if there are multiple promises). As a result, for a right-to-use license, revenue would be recognized no earlier than when the subsequent usage occurs.

The above issue is addressed in Implementation Q&A 58 (compiled from previously issued TRG Agenda Papers 45 and 49). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

12.3.3.3 Customer’s Ability to Access or Download Additional Copies of Software

Whether an entity (i.e., a software vendor) is involved in reproducing software copies does not in itself determine whether an arrangement includes rights to additional users or usage of software. The example below illustrates how an entity (the vendor) in a software arrangement with a customer should account for the customer’s ability to access or download additional copies of software when adding users may or may not require additional direct involvement by the vendor.

Example 12-8

A customer in a software arrangement pays a fixed fee of $300,000 for up to 500 copies of the software. Each copy can only have a single user. The customer pays an additional $400 per copy for copies in excess of the initial 500. The number of copies is measured, and the customer pays for any additional users each quarter.

Consider the following scenarios:

Scenario A — The customer has been given a master copy of the software and has the technical capability and legal right to create an unlimited number of copies without any further assistance from the vendor.
Scenario B — The customer has been given access to download copies of the software and has the technical capability and legal right to download an unlimited number of copies without any further direct involvement by the vendor.
Scenario C — The customer must request, and the vendor must provide, access codes for any additional downloads

The vendor must use judgment to determine whether the additional copies in a particular fact pattern should be regarded as additional usage (one license) or additional users (multiple licenses). However, this judgment is not solely affected by whether adding users requires additional direct involvement by the vendor.

In Scenario C, the fact that the customer cannot obtain additional copies of the software without the vendor’s direct involvement does not in itself prevent the nature of the arrangement from being additional usage (one license). As discussed in Example 12-16, control of software may be determined to have passed to a customer before the software is downloaded if the seller has nevertheless made the software available.

In Scenarios A and B, if the nature of the arrangement is determined to be additional users (multiple licenses), the fact that the customer can obtain additional copies of the software without the vendor’s direct involvement does not in itself mean that the customer controls the additional licenses and that the vendor has satisfied its performance obligation. The vendor’s performance obligation includes not only making the IP available to the customer but also the act of granting those rights.

Accordingly, the outcome of the accounting analysis does not depend on whether adding copies of a license requires additional direct involvement by the vendor. In all three scenarios above, the vendor should evaluate the arrangement to determine whether the contract provides for additional users (i.e., separate performance obligations that should be evaluated in accordance with the guidance in ASC 606-10-55-42 on options to acquire additional goods or services) or additional usage of a single license that was already delivered. The accounting for the initial 500 copies (i.e., the committed volume by the customer) is not the subject of this example. Rather, this example addresses only the additional copies in excess of the initial 500 copies to be delivered to the customer.

12.3.3.4 Recognition of Revenue From Software Arrangements When Additional Amounts Due Are Identified Through a Customer Audit

In certain software licensing arrangements, a customer may have the option to purchase additional licenses without direct involvement from the software vendor. For example, a customer may have the ability to use additional licenses without first issuing a purchase order but instead is required to self-report (and subsequently pay for) any additional licenses used. In other software licensing arrangements, a customer may not have the ability to use additional licenses without entering into another contract with the software vendor for additional licenses.

It is common for a software vendor to have the right to audit the number of licenses used by its customers. Such a license audit could result in (1) the identification of additional licenses beyond what the customer self-reported or is entitled to use and, therefore, (2) additional license fees. The examples below illustrate the accounting for software arrangements when a license audit results in the identification of additional licenses used by the customer.

Example 12-9

Entity S, a software vendor, enters into a three-year term-based license agreement with Customer C on January 1, 20X1. Under the terms of the agreement, C has the right to 100 licensed users of the software at a price of $10 per user per year. The agreement includes an option to purchase the right to additional licensed users each year (determined to be optional purchases rather than variable consideration; see Section 12.3.3), also for $10 per user per year. Customer C is not required to first issue a purchase order to S to acquire and use additional user licenses on its own, but it must provide a report to S on the number of licenses used each year. Entity S has the right to audit how many licenses to the software C has used. The option to purchase additional licenses does not represent a material right because the price per additional user per year is the stand-alone selling price.

On March 1, 20X1, C uses 10 additional software licenses (for a total of 110 licensed users) but does not report the increase to S. On February 15, 20X2, S performs an audit of C’s users and identifies the 10 additional software licenses. Entity S intends to enforce its right to collect the additional fee of $10 per licensed user per year and invoices C $100 (10 additional licensed users per year × $10 per additional licensed user × 1 year) on March 1, 20X2.

Entity S prepares financial statements for the year ended December 31, 20X1, that are issued on February 28, 20X2. The information identified in the audit is a recognized subsequent event because C exercised its contractual option to acquire rights to additional licensed users and such rights were transferred to C on March 1, 20X1. Accordingly, even though S was not aware of the additional licenses being transferred, the information obtained as a result of the audit confirmed that S had an enforceable right to additional consideration for promised goods or services (i.e., licenses) transferred to C on March 1, 20X1, as a result of the optional purchases made by C during the year ended December 31, 20X1.

Example 12-10

Assume the same facts as in the example above, except that Customer C is not contractually authorized to use additional licenses without entering into a separate contract with Entity S. On February 15, 20X2, as a result of the audit, S and C negotiate and execute a separate contract for additional licenses. Because C anticipates that it will need only five additional licenses for the remainder of the term, S agrees to only charge C for those additional licenses for an additional license fee of $150 (5 additional licenses per year × $10 per additional license × 3 years), which is invoiced at the time the separate contract is executed.

Because C did not have a contractual right to the additional users throughout 20X1, S (1) did not transfer rights to additional users in 20X1 and (2) does not have a contractual right to additional consideration for the additional users as of December 31, 20X1 (since the additional users were not covered by a legally enforceable contract as of December 31, 20X1). Accordingly, S concludes that (1) a legally enforceable contract for the additional licenses does not exist as of December 31, 20X1, and (2) the additional rights in the separate contract are not transferred to C until February 15, 20X2. Consequently, S should not record revenue for the additional users in the year ended December 31, 20X1.

12.3.4 Accounting for Bundled Licensing Arrangements — Right to Use New Content

In certain cases, a TV network may license its library of historical content as well as provide a right to use all future content it develops to a broadcaster that is seeking to be the distributor of the TV network’s content in the broadcaster’s territory. As part of the transaction, the TV network might also provide the broadcaster the right to sell a digital streaming subscription service that includes access to the historical content as well as all future content.

The example below illustrates how an entity should determine whether a license to use a library of historical content and all future content represents more than one performance obligation.

Example 12-11

Network XYZ, a U.S.-based cable TV network, enters into a three-year arrangement with a foreign distributor. In accordance with the arrangement:

The foreign distributor is granted an exclusive license that includes digital streaming rights (in the foreign distributor’s territory) to XYZ’s library of historical content as well as XYZ’s new content that becomes available during the three-year term. Network XYZ has determined that its license to historical and new content is a license to functional IP.
The foreign distributor plans to launch its XYZ Network subscription service in its territory at the inception of the arrangement.
The library of historical content is transferred to the foreign distributor at inception.
Network XYZ’s new content is made available after it is aired on Network XYZ and is immediately added to the library available to the foreign distributor for digital streaming.

The foreign distributor believes that potential subscribers to its service attach a significant degree of importance to XYZ’s new content. Therefore, the foreign distributor believes that if it did not have access to the new content, it would face a challenge in attracting subscribers — even at a lower price — to a subscription service containing only the content available at contract inception.

The right to use the library of historical content and all future content would generally represent two performance obligations. In accordance with ASC 606-10-25-19 through 25-22, XYZ is required to assess whether the promise to grant a license to the existing content is distinct from the right to use new content when and if new content is made available by XYZ. For licenses of functional IP, it is important to determine whether updates (e.g., rights to use new content) significantly affect the functionality of the license transferred at inception. In the determination of whether the license is capable of being distinct, we would expect that the foreign distributor can benefit from the functionality provided by the existing content on its own without the updates. Although the updates may be important for the foreign distributor to attract subscribers, the updates do not significantly modify the functionality of the historical content, and the historical content does not significantly modify the functionality of the new content. In addition, the historical content and the new content are not significantly integrated, highly interdependent, or highly interrelated, and XYZ can satisfy its promise to transfer the rights to use the historical library of content independently from satisfying its promise to transfer the right to use new content.

However, entities should carefully analyze their facts and circumstances.

12.3.5 Identifying Performance Obligations in a Hybrid Software Arrangement

Software providers may offer hybrid solutions in which a customer may have the right to deploy the software (1) as either on-premise software or a cloud-based service (with the ability to switch from one to the other as needed) or (2) by using the on-premise software together with the cloud-based service. On-premise software is installed and runs on the customer’s devices (e.g., computers and servers) or is hosted by a third party under a separate contract between the customer and that third party.8 A cloud-based service involves software that is physically hosted on the software provider’s systems (or hosted by the software provider’s cloud-computing vendor) and accessed by the customer over the Internet. In arrangements involving these hybrid solutions, questions arise about how to identify the promises (and, therefore, the performance obligations) in the contract.

Example 12-12

An entity enters into a three-year contract with a customer to provide 1,000 licenses of Product X for a nonrefundable fee of $100,000. Under the terms of the contract, the customer has an option to deploy the 1,000 licenses as either on-premise software or a cloud-based service throughout the three-year license term. Assume that the on-premise software and the cloud-based service (1) each are fully functional on their own and (2) provide effectively the same functionality to the customer. At contract inception, the customer decides to use 600 licenses of Product X as on-premise software and 400 licenses of Product X as a cloud-based service. Six months later, the customer decides to use 500 licenses of Product X as on-premise software and 500 licenses of Product X as a cloud-based service.

We believe that it is reasonable to conclude that the entity has promised (1) to provide the right to use 1,000 software licenses of Product X and (2) to stand ready to provide a cloud-based service (i.e., to host the software licenses). If each of the promises is distinct, there are two performance obligations to which the nonrefundable $100,000 fee should be allocated on a relative stand-alone selling price basis (refer to Chapter 7 for a discussion about allocating the transaction price). Consideration allocated to Product X (i.e., the on-premise software licenses) would be recognized once control of Product X is transferred to the customer (refer to the discussion in Section 12.5). Since the performance obligation to provide the hosting service is satisfied over time, consideration allocated to this performance obligation should be recognized as revenue over the three-year contract term (i.e., the period over which the entity is required to stand ready to provide the hosting service).

The functionality of on-premise software and a cloud-based service in a hybrid cloud-based arrangement can vary between offerings to customers and between entities. When identifying performance obligations in a hybrid cloud-based arrangement, an entity should consider the guidance in ASC 606-10-25-19 through 25-21 to determine whether the on-premise software and the cloud-based service are distinct (see Chapter 5 for further discussion of the guidance on determining whether promises in a contract are distinct).

Example 9-2-3 of the AICPA Audit and Accounting Guide Revenue Recognition states, in part:

Many hybrid offerings will enable customers to perform some functions with the on-premise software even when they are not connected to the hosting service. An entity may determine that the on-premise software meets the criteria of FASB ASC 985-20-15-5 and is capable of being distinct. However, even when the software license is within the scope of FASB ASC 606-10-55-54a and is capable of being distinct, it may not be distinct in the context of the contract because it is, for example, highly interdependent or interrelated with the hosting service. In making this determination, the entity may consider indicators such as the following:

Hosted functionality is limited to capabilities that are widely available from other vendors. For example, the entity offers online file storage and sharing with minimal integration to the on-premise software workflow. In such cases, a customer could gain substantially all of the benefits included in the offering by utilizing alternative vendor services. This would indicate that the software license likely is both capable of being distinct from the hosted service and distinct within the context of the contract because the entity is not providing unique and additional value from the integration of the software and the file storage.
A portion of the hosted functionality is available from other vendors, but the entity provides significant additional utility from the manner in which it integrates the software with its own hosted functionality. For example, the online storage and sharing is integrated with the on-premise software in such a manner that the customer gains significant capabilities or workflow efficiencies that would not be available when using another vendor’s hosted services. In such circumstances, the on-premise software is capable of being distinct, but the customer obtains a significant functional benefit by purchasing the complete hybrid offering from the entity. This may indicate that the software license and hosting service are highly interrelated to each other and are not distinct within the context of the contract.
Hosted functionality is limited to functions that the customer may also perform locally with the on-premise software. For example, the customer has the option to perform computationally intensive tasks on its own computer or upload them to the entity’s servers as part of the hosting service. In such circumstances, the customer can obtain the intended benefit of the offering with only the on-premise software. This may indicate that the software is not highly dependent on or interrelated with the hosting service and is therefore distinct within the context of the contract.
The hybrid offering workflow involves ongoing interactions between the on-premise software and hosted services. As a result, the utility of the offering would be significantly diminished if the customer is not connected to the hosting service. For example, the utility of the offering would be significantly diminished if the customer is unable to perform computationally intensive tasks when not connected to the hosting services. In such circumstances, the software and hosted services are highly interdependent or interrelated because (1) the customer gains significant functionality from the software and hosting services functioning together and (2) the entity fulfills its overall promise to the customer only by both transferring the on-premise license and providing the hosting services. This would indicate that the software is not distinct within the context of the contract.

In addition, in determining whether its on-premise software is distinct from its cloud-based service, an entity may consider the following indicators, which are not individually determinative or all-inclusive:

Whether the entity’s on-premise software and cloud-based service are ever sold separately — The entity’s practice of selling the on-premise software or the cloud-based service separately typically indicates that there are two separate performance obligations (i.e., the promises should not be combined) since the customer may benefit from the on-premise software or the cloud-based service on its own. Separate sales also suggest that the on-premise software and the cloud-based service each have significant stand-alone functionality, which indicates that they are distinct within the context of the contract. For example, if the on-premise software separately provides substantially the same functionality as the cloud-based service, the two promises are likely to be distinct.
Whether the customer can benefit from each product or service (i.e., the on-premise software or the cloud-based service) either on its own or together with other resources that are readily available to the customer — For example, suppose that the customer has the ability to (1) obtain the same or similar cloud-based service from a different vendor, (2) use the alternative vendor’s cloud-based service with the entity’s on-premise software, and (3) receive substantially the same combined functionality as that of the entity’s hybrid offering. That ability may indicate that the entity’s on-premise software and cloud-based service each are capable of being distinct and are distinct within the context of the contract since (1) the entity is not providing a significant integration service for the on-premise software and the cloud-based service and (2) it is less likely that the on-premise software and the cloud-based service are highly interdependent or highly interrelated.

Alternatively, suppose that the functionality of the on-premise software is significantly integrated with (rather than just improved by) the cloud-based service in such a way that the entity’s hybrid offering provides significant additional capabilities that cannot be obtained from an alternative vendor providing the cloud-based service. In that case, the presence of an alternative vendor providing a portion of the same utility with its cloud-based service could indicate that the promises are capable of being distinct, but the integrated nature of the promises could indicate that the promises are not distinct within the context of the contract.
Whether the cloud-based service significantly modifies the on-premise software — The cloud-based service and the on-premise software may not be distinct within the context of the contract if rather than just enhancing the capabilities of the on-premise software, the cloud-based service modifies and significantly affects the functionality of the on-premise software. For example, suppose that the cloud-based service (1) employs artificial intelligence (AI) or machine learning that teaches and significantly affects the functionality of the on-premise software and (2) cannot employ the AI or machine learning without using the functionality of the on-premise software. This situation could indicate that the cloud-based service and the on-premise software are not distinct within the context of the contract because rather than just enhancing the capabilities of the on-premise software, the cloud-based service modifies and significantly affects the functionality of the on-premise software.
Whether the absence of either the on-premise software or the cloud-based service significantly limits or diminishes the utility (i.e., the ability to provide benefit or value) of the other — If the on-premise software’s functionality is significantly limited or diminished without the use of the cloud-based service, and vice versa, that significantly limited or diminished functionality may indicate that the on-premise software and the cloud-based service (1) are highly interdependent or highly interrelated (i.e., they significantly affect each other) and (2) function together as inputs to a combined output. This, in turn, may indicate that the promises are not distinct within the context of the contract since the customer cannot obtain the intended benefit of the on-premise software or the cloud-based service without the other. That is, while the customer may be able to obtain some functionality from the on-premise software on a stand-alone basis, it would not obtain the intended outputs from the on-premise software if the on-premise software is not connected to the cloud-based service because the cloud-based service is critical to the customer’s intended use of the hybrid solution. In this situation, the entity cannot fulfill its promise to the customer by transferring the on-premise software or the cloud-based service independently (i.e., the customer could not choose to purchase one good or service without significantly affecting the other good or service in the contract).
Whether the functionality of the combined on-premise software and cloud-based service is transformative rather than additive — Transformative functionality should be assessed separately from additive functionality. Transformative functionality comprises features that significantly affect the overall operation and interaction of the on-premise software and the cloud-based service (e.g., collaboration, pushdown learning, customization). To be transformative, the on-premise software and the cloud-based service must significantly affect each other. That is, the on-premise software and the cloud-based service are inputs to a combined output such that the combined output has greater value than, or is substantively different from, the sum of the inputs. By contrast, additive functionality comprises features that provide an added benefit to the customer without substantively altering (1) the manner in which the functionality is used and (2) the benefits derived from the functionality of the on-premise software or the cloud-based service on a stand-alone basis. Even if added functionality is significant, it may not be transformative. It is more likely that the on-premise software and the cloud-based service are highly interdependent or highly interrelated when the functionality of the combined on-premise software and cloud-based service is transformative rather than additive.
Whether the entity’s marketing materials support a conclusion that the arrangement is for a combined solution rather than separate products or service offerings — The entity’s marketing materials may help clarify what the entity has promised to deliver to its customer and may provide evidence of the customer’s intended use of the on-premise software and the cloud-based service. Circumstances in which an entity markets its product as a “solution” (i.e., the marketing materials discuss the functions, features, and benefits of the combined offering with little or no discussion of the on-premise software and the cloud-based service separately) may help support a conclusion that the entity’s promise is a combined performance obligation. However, the entity should exercise caution when relying on its marketing materials since the manner in which the entity markets its hybrid offering would not, by itself, be sufficient to support a conclusion that the on-premise software and the cloud-based service represent a combined performance obligation.

Identifying performance obligations in hybrid cloud-based arrangements requires judgment, and the determination of whether offerings in such arrangements constitute a single performance obligation or multiple performance obligations will depend on the facts and circumstances. A conclusion that the offerings in a hybrid cloud-based arrangement represent a single performance obligation should be carefully considered under ASC 606-10-25-19 through 25-21.

Example 12-13

Entity A is a developer of modeling software that enables its customers to analyze, design, and render virtual prototypes to assess the real-world impact of products its customers are developing. Entity A enters into a three-year noncancelable contract with a customer to provide (1) an on-premise license to the software and (2) a cloud-based service, which is an online repository for in-process and final prototypes that can be accessed by the customer’s employees from any device that also has the on-premise software. While the on-premise software and the cloud-based service are never sold separately and are marketed as an integrated offering, the on-premise software is fully functional without the cloud-based service and has significant utility on its own. The cloud-based service provides the added benefit of allowing the customer’s employees to share and collaborate on projects but is similar to other cloud-based services provided by alternative vendors. Those other cloud-based services would require only minimal modifications to function with A’s on-premise software.

We believe that it is reasonable to conclude that the on-premise software license and the cloud-based service are two separate performance obligations for the following reasons:

While the on-premise software and the cloud-based service are not sold separately and are marketed as an integrated offering, there are other vendors that provide similar cloud-based services.
The cloud-based service does not significantly modify the on-premise software but merely serves as a repository for sharing prototypes.
The on-premise software is not significantly integrated with the cloud-based service since alternative cloud-based services would require only minimal modifications to function with the on-premise service.
The absence of the cloud-based service does not significantly limit or diminish the utility of the on-premise software (the intended use of the on-premise software is to analyze, design, and render virtual prototypes).
The functionality provided by the cloud-based service (added storage and collaboration functionality) is additive rather than transformative.

Example 12-14

Entity B is a developer of modeling software that enables its customers to analyze, design, and render virtual prototypes to assess the real-world impact of products its customers are developing. Entity B enters into a three-year noncancelable contract with a customer to provide (1) an on-premise license to the software and (2) a cloud-based service. The cloud-based service serves as an online repository for in-process and final prototypes that can be accessed by the customer’s employees from any device that also has the on-premise software. In addition, the cloud-based service interacts with the on-premise software to provide continuous real-time data updates, data mining and analysis, predictive modeling, and machine-based learning (which are computationally intensive tasks that can be performed only through the cloud-based service) to enable the customer to enhance and improve its products. The nature of the customer’s products makes their continual enhancement and improvement critical because without such continual enhancement and improvement, the products would quickly become obsolete. Similarly, functions performed by B’s cloud-based service are critical because without those functions, the on-premise software would have little utility to the customer.

The on-premise software and the cloud-based service are never sold separately and are marketed as an integrated offering. There is significant integration of, and interaction between, the on-premise software and the cloud-based service such that together, they provide the functionality required by the customer. The cloud-based service is proprietary and can be used only with the on-premise software; no other competitors can provide (1) a similar service that can function with B’s on-premise software or (2) a software product that can function with B’s cloud-based service. Accordingly, B determines that there is a transformative relationship between the on-premise software and the cloud-based service such that they are inputs to a combined output. Further, because the on-premise software and the cloud-based service each have little or no utility without the other, they are highly interrelated and highly interdependent.

We believe that it is reasonable to conclude that there is one performance obligation (an integrated hybrid cloud-based offering) for the following reasons:

Entity B’s on-premise software and cloud-based service are never sold separately.
The customer cannot benefit from the on-premise software or the cloud-based service either on its own or together with other resources that are readily available to the customer. There is no on-premise software or cloud-based service available from other vendors that can function with B’s offering.
The functionality of the on-premise software is significantly integrated with that of the cloud-based service in such a way that only together can the on-premise software and the cloud-based service provide the functionality (i.e., the intended benefit) required by the customer.
The absence of either the on-premise software or the cloud-based service significantly limits or diminishes the utility (i.e., the ability to provide benefit or value) of the other. The on-premise software’s functionality is significantly limited or diminished without the use of the cloud-based service, and vice versa. Therefore, the on-premise software and the cloud-based service (1) are highly interdependent and highly interrelated (i.e., they significantly affect each other) and (2) function together as inputs to a combined output. The customer cannot obtain the full intended benefit of the on-premise software or the cloud-based service on a stand-alone basis because each is critical to the customer’s intended use of the hybrid solution. Therefore, B cannot fulfill its promise to the customer by transferring the on-premise software or the cloud-based service independently (i.e., the customer could not choose to purchase one good or service without significantly affecting the other good or service in the contract).
The functionality of the combined on-premise software and cloud-based service is transformative rather than additive. That transformative functionality comprises features that significantly affect the overall operation and interaction of the on-premise software and the cloud-based service in such a way that the on-premise software and the cloud-based service significantly affect each other.
Entity B’s marketing materials support a conclusion that the arrangement is for a combined solution rather than separate product or service offerings.

Footnotes

Cases A and B of Example 10, on which Case C is based, are reproduced in Section 5.3.2.3.

While this section addresses additional rights associated with users, additional rights could also include other incremental licenses, such as the right to use the software at additional locations or for different business segments.

In accordance with ASC 606-10-55-54 and ASC 985-20-15-5, software subject to a hosting arrangement is a license of IP (i.e., on-premise software) if, as stated in ASC 985-20-15-5, (1) the “customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty” and (2) “[i]t 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.”

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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.