12.7 Sales- or Usage-Based Royalties

An entity may license its IP to a customer and in exchange receive consideration that may include fixed and variable amounts. Certain licensing arrangements require the customer to pay the entity a variable amount based on the underlying sales or usage of the IP (a “sales- or usage-based royalty”). As discussed in Chapter 6, the revenue standard requires an entity to estimate and constrain variable consideration in a contract with a customer. The FASB and IASB decided to create an exception to the general model for consideration in the form of a sales- or usage-based royalty related to licenses of IP.

ASC 606-10

55-65 Notwithstanding the guidance in paragraphs 606-10-32-11 through 32-14, an entity should recognize revenue for a sales-based or usage-based royalty promised in exchange for a license of intellectual property only when (or as) the later of the following events occurs:

The subsequent sale or usage occurs.
The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).

Under the sales- or usage-based royalty exception to the revenue standard’s general rule requiring an entity to include variable consideration in the transaction price, if an entity is entitled to consideration in the form of a sales- or usage-based royalty, revenue is not recognized until (1) the underlying sales or usage has occurred and (2) the related performance obligation has been satisfied (or partially satisfied). That is, an entity is generally not required to estimate the amount of a sales- or usage-based royalty at contract inception; rather, revenue would be recognized as the subsequent sales or usage occurs (under the assumption that the associated performance obligation has been satisfied or partially satisfied).

ASC 606-10

55-65A The guidance for a sales-based or usage-based royalty in paragraph 606-10-55-65 applies when the royalty relates only to a license of intellectual property or when a license of intellectual property is the predominant item to which the royalty relates (for example, the license of intellectual property may be the predominant item to which the royalty relates when the entity has a reasonable expectation that the customer would ascribe significantly more value to the license than to the other goods or services to which the royalty relates).

55-65B When the guidance in paragraph 606-10-55-65A is met, revenue from a sales-based or usage-based royalty should be recognized wholly in accordance with the guidance in paragraph 606-10-55-65. When the guidance in paragraph 606-10-55-65A is not met, the guidance on variable consideration in paragraphs 606-10- 32-5 through 32-14 applies to the sales-based or usage-based royalty.

The sales- or usage-based royalty exception only applies if the royalty is associated with a license of IP that is the predominant item. For example, if the royalty is associated with a franchise license and other services provided to a franchisee, the exception would apply if the customer can reasonably expect the franchise license to have significantly more value than the services. Example 60 in ASC 606, which is reproduced below, illustrates a situation in which a license of IP would be considered the predominant item to which a contract’s sales-based royalty is related.

ASC 606-10

Example 60 — Sales-Based Royalty Promised in Exchange for a License of Intellectual Property and Other Goods and Services

55-393 An entity, a movie distribution company, licenses Movie XYZ to a customer. The customer, an operator of cinemas, has the right to show the movie in its cinemas for six weeks. Additionally, the entity has agreed to provide memorabilia from the filming to the customer for display at the customer’s cinemas before the beginning of the six-week airing period and to sponsor radio advertisements for Movie XYZ on popular radio stations in the customer’s geographical area throughout the six-week airing period. In exchange for providing the license and the additional promotional goods and services, the entity will receive a portion of the operator’s ticket sales for Movie XYZ (that is, variable consideration in the form of a sales-based royalty).

55-394 The entity concludes that the license to show Movie XYZ is the predominant item to which the sales-based royalty relates because the entity has a reasonable expectation that the customer would ascribe significantly more value to the license than to the related promotional goods or services. The entity will recognize revenue from the sales-based royalty, the only fees to which the entity is entitled under the contract, wholly in accordance with paragraph 606-10-55-65. If the license, the memorabilia, and the advertising activities were separate performance obligations, the entity would allocate the sales-based royalties to each performance obligation.

12.7.1 Whether to Apply the Sales- or Usage-Based Royalty Exception to Only Part of the Royalties

In some contracts, a single sales- or usage-based royalty may be related to both a license of IP and another good or service (i.e., not a license). After the revenue standard was issued, stakeholders communicated that it is unclear whether a sales- or usage-based royalty should ever be split into a portion to which the sales- or usage-based royalty exception would apply and a portion to which the general constraint on variable consideration in step 3 would apply.

The FASB clarified in ASU 2016-10 that an entity should not split a royalty into a portion that is subject to the sales- or usage-based royalty exception and a portion that is subject to the general constraint on variable consideration in step 3. However, as explained in paragraph BC75(a) of the ASU, “this amendment does not affect the requirement to allocate fees due from a sales-based or usage-based royalty to the performance obligations (or distinct goods or services) in the contract to which the royalty relates, regardless of the constraint model the entity is required to apply.” For an illustration of how an entity would comply with the allocation requirement, see Example 35, Case B, in ASC 606-10-55-275 through 55-279, which is reproduced in Section 7.5.1.

In ASU 2016-10, the FASB also clarified that the sales- or usage-based royalty exception applies when the license is the predominant item (regardless of whether the license is distinct or combined with other goods or services as a single performance obligation) in relation to other nonlicense goods or services. That is, an entity either applies the sales- or usage-based royalty exception in its entirety (if the license to IP is predominant) or applies the general variable consideration guidance (if the license to IP is not predominant). Further, the FASB clarified in paragraph BC75(b) of the ASU that the sales- or usage-based royalty exception would also apply in “situations in which no single license is the predominant item to which the royalty relates but the royalty predominantly relates to two or more licenses promised in the contract.” However, ASC 606 does not define the term “predominant.” As a result, an entity will need to exercise judgment when determining whether the license to IP is predominant.

12.7.2 Interaction of Sales- or Usage-Based Royalty Exception With Measuring Progress Toward Satisfaction of a Performance Obligation

When applying the sales- or usage-based royalty exception, an entity typically would recognize revenue when (or as) the customer’s subsequent sales or usage occurs. However, if the sales- or usage-based royalties accelerate revenue recognition as compared with the entity’s satisfaction (or partial satisfaction) of the associated performance obligation, the entity may be precluded from recognizing some or all of the revenue as the subsequent sales or usage occurs.

ASC 606-10-55-65 specifies that revenue from a sales- or usage-based royalty promised in exchange for a license of IP is recognized only when (or as) the later of the following events occurs:

The subsequent sale or usage occurs.
The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).

Accordingly, revenue should be deferred if, and to the extent that, recognition based on subsequent sales or usage (i.e., criterion (a)) is judged to be in advance of satisfaction of a performance obligation (i.e., criterion (b)). Royalty arrangements can differ greatly between entities and between contracts. Further, the timing of the recognition of royalties can depend on the nature of the underlying IP (i.e., right to access or right to use) as well as the structure of the royalty payments. Therefore, the determination of whether revenue from royalties should be deferred will depend on an analysis of the specific facts and circumstances. For example, if the performance obligation to which the royalties are related is a right-to-access license of IP, it will often be helpful to consider whether the structure of the royalty payments appropriately depicts progress toward satisfying the performance obligation of providing access to the entity’s IP throughout the license period. If the structure of the royalty payments does appropriately depict such progress, the criteria in ASC 606-10-55-65(a) and (b) will coincide, and no deferral of revenue will be necessary.

Whereas the amount determined under criterion (a) will be essentially a matter of fact (actual sales or usage multiplied by the applicable royalty rate), an entity will typically need to use judgment to determine the amount under criterion (b). In particular, it will be important for an entity to identify an appropriate measure of progress toward complete satisfaction of its obligation (e.g., providing access to the entity’s IP) in accordance with ASC 606-10-25-31. The entity should then apply the guidance in ASC 606-10-55-65 to determine whether any revenue from royalties that have become payable on the basis of sales or usage exceeds the amount of revenue that the entity determined by applying the identified measure of progress. If so, the entity should defer that excess and recognize it as a contract liability.

Note that ASC 606-10-55-65 requires an entity to recognize revenue upon the occurrence of the later of the events described in ASC 606-10-55-65(a) and (b). Consequently, it is never possible to recognize revenue in advance of the amount payable under criterion (a) (actual sales or usage multiplied by the applicable royalty rate), even if royalty rates have been back-end loaded in such a way that royalties lag behind the measure of progress identified.

The example below illustrates the accounting for royalties related to a right-to-access license under various scenarios.

Example 12-28

Entity S, a sports team, enters into a noncancelable license agreement with Entity C, a clothing manufacturer, under which C can use the sports team’s logo on the shirts it manufactures and sells. The license is a right to access S’s IP and is transferred to C over time.

Consider the following scenarios:

Scenario 1 — The license is for a five-year period in exchange for a flat-rate royalty payable to S for every shirt sold. During the first year of the contract, a sporting competition is held. As a result of the sporting competition, the clothing manufacturer sells a much larger than normal number of shirts.
Scenario 2 — The license arrangement is such that the first shirt sold triggers a royalty payment of $1 million to S and the next 999,999 units sold do not trigger any further royalty payments. Each sale in excess of 1 million items triggers a $1 royalty.

Scenario 1

In Scenario 1, S concludes that it is reasonable for the higher royalty payments in the first year of the license to reflect a higher proportion of the total license value being transferred to C in that year because C has sold a disproportionately large number of shirts. Accordingly, the structure of the royalty payments appropriately depicts progress toward satisfying S’s performance obligation of providing access to its IP throughout the license period. It is unnecessary for S to defer any of the royalty payments received in year 1 over the remainder of the license term.

In this example, although the royalties payable are higher in the first year of the royalty arrangement, the magnitude of the royalty payments corresponds to greater value received by the customer in that year and, consequently, is still consistent with progress toward satisfaction of the performance obligation over time.

Scenario 2

In Scenario 2, S would be likely to conclude that the first royalty payment of $1 million corresponds to the benefit of the license being transferred for the first 1 million sales made by C. Accordingly, S could recognize the first royalty payment of $1 million over the period in which the first 1 million shirts are sold. For any sales made in excess of the first 1 million items, S would recognize the royalty payments of $1 per shirt sold upon the sale of each item because the structure of those subsequent royalty payments aligns with the transfer of the benefit of the license to C.

In this scenario, it would not be appropriate for S to recognize as revenue the entire $1 million royalty payment received when the first shirt is sold because that would not be a reasonable reflection of the progress toward satisfaction of S’s performance obligation. Because the royalties have been front-end loaded in a way that does not reflect the value to the customer, the royalties that have become payable on the basis of sales or usage exceed the amount of revenue that S determined by applying an appropriate measure of progress. Therefore, revenue recognized is restricted to the latter.

The example below illustrates the accounting for variable royalty rates over the term of a right-to-access license.

Example 12-29

Entity S, a sports team, enters into a noncancelable license agreement with Entity M, a manufacturer, under which M can use the sports team’s logo on a product that it manufactures and sells. The license is a right to access S’s IP and is transferred to the customer over time. The license is for a five-year period in exchange for a royalty for every product sold.

The royalty rate decreases during the term of the license: in years 1 through 3, M is required to pay 10 percent of the sales price of the product to S, whereas in years 4 and 5, M is required to pay 8 percent of the sales price of the product to S. The volume of product sales on which the royalty is based is expected to be approximately equal for each of the five years of the license.

To apply the guidance in ASC 606-10-55-65, S will need to determine an appropriate measure of progress toward satisfying the performance obligation over time. Entity S could consider whether the structure of the royalty payments appropriately depicts progress toward satisfying its performance obligation to provide access to its IP throughout the license period.

Although the royalty rate decreases for the last two years of the license period, S might conclude that the structure of the royalty payments appropriately depicts progress toward satisfying its performance obligation if the change in rate reflects the decreased value of the license to M in those years. For example, this might be the case if M’s product was expected to have a higher selling price in years 1 through 3 than in years 4 and 5; the reduction in royalty rate might have been intended to reflect the lower gross margins that M could expect in years 4 and 5 and, consequently, the lower value of the license to M in those years.

However, if the structure of the royalty payments does not appropriately depict progress toward satisfying S’s performance obligation, S will need to determine an appropriate measure of progress and use this to apply the guidance in ASC 606-10-55-65. For example, because the volume of product sales is expected to be broadly flat, S may conclude that it is reasonable to regard the benefit of the license as being transferred to M on a straight-line basis over time. If so, S will need to develop an appropriate method for determining what amount of royalties received should be deferred to meet the requirements of ASC 606-10-55-65. For example, if S is able to reasonably estimate the royalties, it could apply a blended rate to recognize revenue if doing so would result in an appropriate measure of progress and would not result in recognizing revenue before the underlying sales or usage occurs.

The example below illustrates the accounting for variable royalty rates paid in exchange for a right-to-use license.

Example 12-30

An entity enters into a contract to provide a customer with a noncancelable license to the entity’s IP. There are no other promised goods or services in the contract. The entity determines that the license is a right-to-use license (i.e., a license for which revenue is recognized at a point in time) for a three-year period. The customer’s estimated sales are expected to be approximately equal for each of the three years under license. For the use of the IP, the agreement requires the customer to pay the entity a royalty of 10 percent of the customer’s sales in year 1, 8 percent of the customer’s sales in year 2, and 6 percent of the customer’s sales in year 3.

The entity should account for the royalty payments in a manner consistent with the legal form of the arrangement and in accordance with the exception to the variable consideration guidance for licenses of IP that include a sales- or usage-based royalty. Consequently, the entity would include the royalties in the transaction price on the basis of the applicable contractual rate and the customer’s sales in each year and then, in accordance with ASC 606-10-55-65, recognize revenue at the later of when (1) the “subsequent sale or usage occurs” or (2) the “performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).” Because the license is a right-to-use license for which control is transferred at the inception of the contract, the “later” of the two conditions is met when the subsequent sales occur.

12.7.3 Scope of the Sales- or Usage-Based Royalty Exception

12.7.3.1 Sale of IP Versus License of IP in Exchange for a Sales- or Usage-Based Royalty

The sales- or usage-based royalty exception is limited to narrow circumstances in which the entity licenses its IP. Stakeholders have questioned the scope of the sales- or usage-based royalty recognition constraint in arrangements that are economically similar but legally different.

The sales- or usage-based royalty exception in ASC 606-10-55-65 should be applied by the licensor when accounting for the transfer of a license of IP promised in exchange for a sales- or usage-based royalty; a sale of IP does not qualify for the exception and, accordingly, would be accounted for under the general revenue measurement and recognition guidance in ASC 606.

The FASB and IASB decided against applying the exception for sales- or usage-based royalties to IP more broadly. As indicated in paragraph BC421 of ASU 2014-09, the boards believed that although the exception “might not be consistent with the principle of recognizing some or all of the estimate of variable consideration,” the disadvantage of such an inconsistency in these limited circumstances is “outweighed by the simplicity of [the exception’s requirements], as well as by the relevance of the resulting information for this type of transaction.” Further, the boards concluded that the exception should not be applied “by analogy to other types of promised goods or services or other types of variable consideration.” The boards’ full rationale for their decision is set out in paragraphs BC415 through BC421 of ASU 2014-09. In addition, the sales- or usage-based royalty exception should be applied to a contract that is a licensing arrangement in form even if the arrangement is an in-substance sale of IP. That is, the legal form of the transaction will determine which revenue accounting guidance is applied (see Section 12.2.2).

Example 12-31

Entity X provides its customer with a license to broadcast one of X’s movies on the customer’s networks in exchange for a royalty of $10,000, which is payable each time the movie is broadcasted over the five-year license period. Entity X considers the guidance in ASC 606-10-55-59 through 55-64A and concludes that X has promised to its customer a right to use X’s IP (i.e., X has satisfied its performance obligation at the point in time at which the customer is able to use and benefit from the license).

Entity X applies the requirements of ASC 606-10-55-65 and does not recognize any revenue when the license is transferred to the customer. Instead, X recognizes revenue of $10,000 each time the customer uses the licensed IP and broadcasts X’s movie.

Example 12-32

Entity X sells the copyright to one of its music albums (i.e., all rights related to the IP) to a customer in exchange for a promise of future payments equal to $1 for each album sold by the customer in the future and $0.01 for each time a song on the album is played on the radio. Entity X considers the guidance in ASC 606-10-25-23 through 25-30 and determines that its performance obligation is satisfied at the point in time at which it transfers the copyright to the customer.

Entity X should not apply the sales- or usage-based royalty exception in ASC 606-10-55-65. Rather, in accordance with ASC 606-10-32-2 and 32-3, upon transferring control of the IP to the customer, X recognizes revenue equal to its estimate of the amount to which it will be entitled, subject to the constraint on variable consideration specified by ASC 606-10-32-11 and 32-12. Entity X then updates its estimate and records a cumulative catch-up adjustment at each subsequent reporting period as required by ASC 606-10-32-14.

12.7.3.2 Whether Application of the Sales- or Usage-Based Royalty Exception Is Optional

The guidance in ASC 606-10-55-65 must be applied whenever a license to IP that is the predominant item is subject to a sales- or usage-based royalty. That is, applying the exception is not optional when the consideration due in a licensing arrangement is in the form of a sales- or usage-based royalty. Consider the examples below.

Example 12-33

Entity LN, a professional basketball team, licenses its logo to a manufacturer of sports apparel and receives a royalty payment for each item of sports apparel sold. Entity LN has historical experience that is highly predictive of the amount of royalties that it expects to receive.

The sales- or usage-based royalty exception in ASC 606-10-55-65 states that revenue should be recognized at the later of when (1) the “subsequent sale or usage occurs” or (2) the “performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).” The application of the sales- or usage-based royalty exception is not optional, and LN would be precluded from recognizing the royalty revenue until the later of (1) the actual sale of the sports apparel or (2) LN’s satisfaction of the performance obligation to which the sales- or usage-based royalty is related.

Example 12-34

Entity S licenses its software (i.e., functional IP) to an OEM, which then integrates S’s software with its own software for inclusion in hardware devices (e.g., computers, tablets, and smart devices) to be sold to end users. Entity S sells 5,000 licenses to the OEM for $10 per license (i.e., $50,000 in total consideration) that is paid at contract inception. In addition, S provides the OEM with 5,000 activation keys, each of which allows the OEM to download S’s software for integration with the OEM’s software to be included in one hardware device. The license agreement allows the OEM to acquire additional software licenses for $10 per license by requesting additional activation keys, which S readily provides to the OEM. Entity S has concluded that providing additional license keys to the OEM does not transfer any additional rights not already controlled by the OEM (see Section 12.3.3).

The OEM can return any activation keys that are paid for but not used to download and integrate the software for inclusion in the OEM’s devices. The OEM will receive a refund of $10 per license for any activation keys returned.

Because S’s consideration for the transfer of the licensed software (i.e., functional IP) is contingent on the OEM’s subsequent usage, S must apply the sales- or usage-based royalty exception described in ASC 606-10-55-65. It would not be appropriate for S to recognize revenue on the sale of the license with the right of return before the OEM’s subsequent usage.

Although the OEM has paid for the activation keys at contract inception, because the amounts are refundable to the extent that the OEM does not use the IP by integrating it with the OEM’s software to be included in hardware devices, the consideration is in the form of a sales- or usage-based royalty. Entity S would therefore be prohibited from recognizing revenue until the subsequent sale or usage of the IP occurs (in accordance with 606-10-55-65(a)). That is, it would not be appropriate for S to estimate and constrain the amount of consideration to which it expects to be entitled and recognize such at the time the initial 5,000 licenses are transferred to the OEM.

12.7.3.3 Fixed Payments for a License of IP Receivable on Reaching a Sales- or Usage-Based Milestone

In many industries, it is common for contracts related to a license of IP to include payment terms tied to milestones (“milestone payments”). These milestone payments are frequently structured in such a way that entitlement to or payment of an amount specified in the contract is triggered once a sales target (i.e., a specified level of sales) has been reached (e.g., a $10 million milestone payment is triggered once cumulative sales by the licensee exceed $100 million).

Revenue with respect to such milestone payments should be recognized when the sales- or usage-based milestone is reached (or later if the related performance obligation has not been satisfied), as required by the exception for sales- or usage-based royalties set out in ASC 606-10-55-65. This requirement applies to milestone payments triggered by reference to any sales- or usage-based thresholds even when the milestone amount to be paid is fixed.

However, this exception should not be applied to milestone payments related to the occurrence of any other event or indicator (e.g., regulatory approval or proceeding into a beta phase of testing).

Paragraph BC415 of ASU 2014-09 states, “The [FASB and IASB] decided that for a license of intellectual property for which the consideration is based on the customer’s subsequent sales or usage, an entity should not recognize any revenue for the variable amounts until the uncertainty is resolved (that is, when a customer’s subsequent sales or usage occurs).” This paragraph illustrates the boards’ intent that the exception should apply to consideration only when the consideration is (1) related to licenses of IP and (2) based on the customer’s subsequent sales or usage.

12.7.3.4 Application of the Sales- or Usage-Based Royalty Exception to a Refundable Up-Front Payment

There are certain situations in which (1) an up-front payment is made for the sale of a license and (2) the up-front payment is refundable depending on actual sales or usage of the license. In these cases, we believe that the sales- or usage-based royalty exception would apply.

Example 12-35

Entity S licenses its software to an OEM, which then integrates S’s software with its own software in hardware devices (e.g., computers, tablets, and smart devices) to be sold to end users. The license constitutes a right-to-use license under ASC 606-10-55-58(b) and ASC 606-10-55-59(a) (i.e., a license of functional IP). Entity S sells 5,000 licenses to the OEM for $10 per license (i.e., $50,000 in total consideration) that is paid at contract inception. In addition, S provides the OEM with 5,000 activation keys, each of which allows the OEM to download S’s software for integration with the OEM’s own software to be included in one hardware device. The license agreement allows the OEM to acquire additional software licenses for $10 per license by requesting additional activation keys, which S readily provides to the OEM. Entity S has concluded that providing additional license keys to the OEM does not transfer any additional rights not already controlled by the OEM.

The OEM can return any unused activation keys (i.e., with respect to licensed software not integrated with the OEM’s devices). The OEM will receive a refund of $10 per license for any activation keys returned.

Entity S’s consideration for the transfer of the licensed software is contingent on the OEM’s subsequent usage. Accordingly, S must apply the requirements of ASC 606-10-55-65 (with respect to both the initial 5,000 licenses sold and any additional licenses that may be purchased by the OEM).

Although the OEM has paid for the initial 5,000 activation keys at contract inception, because the amounts are refundable to the extent that the OEM does not use the IP by integrating it with the OEM’s software to be included in hardware devices, the consideration is in the form of a sales- or usage-based royalty. Entity S would therefore be prohibited from recognizing revenue until the subsequent usage of the IP occurs (i.e., when the OEM integrates the software with the hardware and no longer has the right to return the activation keys).

Because the sales- or usage-based royalty exception applies to this transaction, it would not be appropriate for S to account for the transaction under the general guidance on sales with a right of return (see Section 6.3.5.3).

12.7.4 Recognition of Sales-Based Royalties When Information Is Received From the Licensee After the End of the Reporting Period

In certain licensing arrangements for which the consideration received from the customer is based on the subsequent sales of IP, information associated with those subsequent sales may not be available before the end of the reporting period. Provided that the related performance obligation has been satisfied or partially satisfied, ASC 606-10-55-65 requires that sales-based royalties received for a license of IP be recognized when the subsequent sale or usage by the licensee occurs. It would not be appropriate to delay recognition until the sales information is received.

Example 12-36

Entity LN enters into a software license with Entity B that allows inclusion of the software in computers that B sells to third parties. Under the terms of the license, LN receives royalties on the basis of the number of computers sold that include the licensed software. Upon delivery of the software to B, LN satisfies the performance obligation to which the sales-based royalty was allocated. Thereafter, LN receives quarterly sales data in arrears, which allow it to calculate the royalty payments due under the license.

Entity LN should recognize revenue (royalty payments) for computer sales made by B up to the end of its reporting period even though sales data had not been received at the end of that reporting period.

In this scenario, royalties should be recognized for sales made by B up to the end of LN’s reporting period on the basis of sales data received before LN’s financial statements are issued or available to be issued. If necessary, LN should estimate sales made in any period not covered by such data. It would not be appropriate for entities to omit sales-based royalties from financial statements merely because the associated sales data were received after the end of the reporting period or were not received when the financial statements were issued or available to be issued.

This conclusion is consistent with the following view expressed in a speech delivered on June 9, 2016, by Wesley Bricker, then deputy chief accountant in the SEC's Office of the Chief Accountant, at the 35th Annual SEC and Financial Reporting Institute Conference:

The standard setters did not provide a lagged reporting exception with the new standard. Accordingly, I believe companies should apply the sales- and usage-based royalty guidance as specified in the new standard. The reporting, which may require estimation of royalty usage, should be supported by appropriate internal accounting controls.

12.7.5 Sales- or Usage-Based Royalties With a Minimum Guarantee

Sometimes, the sales- or usage-based royalty may be subject to a minimum guarantee, which establishes a floor for the amount of consideration to be paid to the entity. The sales- or usage-based royalty exception applies only when the consideration due under the licensing agreement is variable and the variability is directly related to sales or usage of the underlying IP. That is, the exception does not apply to any fixed consideration in a licensing arrangement.

12.7.5.1 Application of the Sales- or Usage-Based Royalty Exception to Guaranteed Minimum Royalties Related to Functional IP

If there are no other performance obligations, a minimum guarantee related to functional IP (i.e., a right-to-use license) should be recognized as revenue at the point in time that the entity transfers control of the license to the customer. Any royalties that exceed the minimum guarantee should be recognized as the subsequent sales or usage related to the IP occurs, in accordance with ASC 606-10-55-65.

Example 12-37

Entity LH enters into a five-year license agreement with Customer MC under which MC can air all of the existing seasons of a TV show in exchange for royalties from MC’s sales and usage of the IP. In addition, the contract contains a minimum guarantee of $1 million per year. The existing seasons of the TV show have stand-alone functionality and thus represent functional IP.

Ignoring potential effects of financing, LH should recognize the total minimum guarantee of $5 million for the contract when control of the functional IP is transferred to the customer and the license period begins. This is because (1) the $5 million is fixed as a result of the minimum guarantee and (2) the underlying IP (i.e., the TV show) is functional (revenue is recognized at a point in time). Additional royalties that exceed the $1 million minimum guarantee in any year should be recognized as the subsequent sales and usage occur.

The above issue is addressed in Implementation Q&A 60 (compiled from previously issued TRG Agenda Papers 58 and 60). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

12.7.5.2 Application of the Sales- or Usage-Based Royalty Exception to Guaranteed Minimum Royalties Related to Symbolic IP

For licenses of symbolic IP, the revenue standard does not prescribe a one-size-fits-all model for recognizing revenue over time in situations in which a sales- or usage-based royalty contract with a customer includes a minimum guaranteed amount of consideration. As discussed at the November 2016 TRG meeting, the following are three acceptable approaches for recognizing revenue in those situations:

Approach A — Recognize revenue as the subsequent sales or usage occurs in accordance with ASC 606-10-55-65 if an entity expects that the total royalties will exceed the minimum guarantee. This approach would be appropriate only if the estimated sales- or usage-based royalties are expected to exceed the minimum guarantee.
Approach B — Estimate the transaction price (as fixed consideration plus expected royalties to be earned over the license term) and recognize revenue over time by using an appropriate measure of progress, but limit cumulative revenue recognized to the cumulative royalties in excess of the minimum guarantee. Like Approach A, this approach would be appropriate only if the estimated sales- or usage-based royalties are expected to exceed the minimum guarantee. Under this approach, an entity will need to periodically revisit its estimate of the total consideration (fixed and variable) and update its measure of progress accordingly (which may result in a cumulative adjustment to revenue).
Approach C — Recognize the minimum guarantee over time by using an appropriate measure of progress over the license period, and recognize incremental royalties in excess of the minimum guarantee as the subsequent sales or usage related to those incremental royalties occurs.

An entity should evaluate its facts and circumstances to determine which method under the standard appropriately depicts its progress toward completion. In addition, entities should consider providing appropriate disclosures to help users of their financial statements understand which approach is being applied. Examples of such disclosures include the key judgments the entity applied in selecting a measure of progress for recognizing revenue from a license of symbolic IP.

The above issue is addressed in Implementation Q&A 59 (compiled from previously issued TRG Agenda Papers 58 and 60). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

The example below further illustrates how to apply the three acceptable approaches for recognizing revenue from symbolic IP arrangements with sales- or usage-based royalties that include minimum guarantees.

Example 12-38

Entity G, a professional sports team, enters into a three-year contract with Entity Y to license G’s team logo trademark (which is symbolic IP). Entity Y intends to include the trademark on various sports merchandise (e.g., hats, shirts, and shorts) and sell this merchandise to end consumers. In exchange for the three-year trademark license, Y will pay G sales-based royalties equal to 6 percent of Y’s gross sales of merchandise that includes G’s trademark. The contract also guarantees a minimum of $1.5 million in royalties for the three-year period.

Over the term of the contract, Y generates annual gross sales, and is therefore required to pay royalties to G, as follows:

Year 1 — Annual gross sales of $15 million, royalties of $900,000.
Year 2 — Annual gross sales of $8 million, royalties of $480,000.
Year 3 — Annual gross sales of $13 million, royalties of $780,000.

Entity G would recognize revenue over the three-year period under Approach A, B, or C in the manner described below.

Approach A

Entity G could apply Approach A only if it expects its estimated sales-based royalties to exceed the minimum guarantee of $1.5 million. Under this approach, G would use a measure of progress that corresponds to the annual gross sales realized by Y (for which there are corresponding royalty payments due to G) and recognize annual revenue in the amounts shown in the table below.

Under Approach A, G would recognize revenue as the subsequent sales occur. Entity G should monitor its estimates of royalties each reporting period and update its measure of progress if it no longer expects to earn total royalties that exceed the minimum guarantee.

Approach B

Like Approach A, Approach B could be applied only if G expects its estimated sales-based royalties to exceed the minimum guarantee of $1.5 million. Under this approach, G would estimate the total transaction price (for the three-year period) and select a measure of progress that results in G’s recognition of the estimated (and constrained) transaction price as G transfers the right to access its symbolic IP to Y. If G uses a time-based measure of progress, it would recognize annual revenue in the amounts shown in the table below.

Under Approach B, G would estimate the total consideration it expects to receive from Y during the three-year period (as fixed consideration for the minimum guarantee plus expected royalties to be earned over the license term) and recognize revenue over time by using an appropriate measure of progress, but limit cumulative revenue recognized to the cumulative royalties due. Therefore, in year 1, G recognizes annual revenue of $720,000, one-third of the total expected consideration to be received of $2.16 million. However, in year 2, G is limited to recognizing revenue of $660,000 because the cumulative royalties received through year 2 is $1.38 million. As a result, the cumulative revenue recognized through year 2 is constrained to the cumulative amount of royalties due.

Entity G should periodically revisit its estimate of the total consideration (fixed and variable) and update its measure of progress accordingly (which may result in a cumulative adjustment to revenue). Entity G should also monitor its estimates of royalties each reporting period and update its measure of progress if it no longer expects to earn total royalties that exceed the minimum guarantee.

Approach C

Entity G would be required to apply Approach C if it does not expect its estimated sales-based royalties to exceed the minimum guarantee of $1.5 million. Under this approach, G would recognize the minimum guarantee over time by using an appropriate measure of progress and recognize incremental royalties in excess of the minimum guarantee as the subsequent sales related to those incremental royalties occur. If G uses a time-based measure of progress, it would recognize annual revenue in the amounts shown in the table below.

Under Approach C, G would recognize $500,000 in each of year 1 and year 2, which is equal to one-third of the minimum guarantee amount of $1.5 million. Entity G would not recognize any variable consideration (i.e., royalties earned above the $1.5 million minimum guarantee) until year 3, when the cumulative consideration received exceeds the minimum guarantee of $1.5 million. The revenue recognized in year 3 is the sum of (1) the remaining $500,000 of the minimum guarantee and (2) the incremental royalties of $660,000 in excess of the minimum guarantee.

12.7.6 Allocating Fixed Consideration and Sales- or Usage-Based Royalties in a Licensing Arrangement With More Than One Performance Obligation

Complexities related to the allocation of the transaction price to multiple performance obligations may arise when licensing contracts include a combination of fixed consideration and royalties subject to the sales- or usage-based royalty exception. As discussed in Section 12.7.5.2, there are several acceptable approaches to accounting for a licensing arrangement that includes both a minimum guaranteed amount and a sales- or usage-based royalty for any sales or usage in excess of that minimum amount in a license of symbolic IP.

ASC 606-10

Example 35 — Allocation of Variable Consideration

55-270 An entity enters into a contract with a customer for two intellectual property licenses (Licenses X and Y), which the entity determines to represent two performance obligations each satisfied at a point in time. The standalone selling prices of Licenses X and Y are $800 and $1,000, respectively.

Case A — Variable Consideration Allocated Entirely to One Performance Obligation

55-271 The price stated in the contract for License X is a fixed amount of $800, and for License Y the consideration is 3 percent of the customer’s future sales of products that use License Y. For purposes of allocation, the entity estimates its sales-based royalties (that is, the variable consideration) to be $1,000, in accordance with paragraph 606-10-32-8.

55-272 To allocate the transaction price, the entity considers the criteria in paragraph 606-10-32-40 and concludes that the variable consideration (that is, the sales-based royalties) should be allocated entirely to License Y. The entity concludes that the criteria in paragraph 606-10-32-40 are met for the following reasons:

The variable payment relates specifically to an outcome from the performance obligation to transfer License Y (that is, the customer’s subsequent sales of products that use License Y).
Allocating the expected royalty amounts of $1,000 entirely to License Y is consistent with the allocation objective in paragraph 606-10-32-28. This is because the entity’s estimate of the amount of sales-based royalties ($1,000) approximates the standalone selling price of License Y and the fixed amount of $800 approximates the standalone selling price of License X. The entity allocates $800 to License X in accordance with paragraph 606-10-32-41. This is because, based on an assessment of the facts and circumstances relating to both licenses, allocating to License Y some of the fixed consideration in addition to all of the variable consideration would not meet the allocation objective in paragraph 606-10-32-28.

55-273 The entity transfers License Y at inception of the contract and transfers License X one month later. Upon the transfer of License Y, the entity does not recognize revenue because the consideration allocated to License Y is in the form of a sales-based royalty. Therefore, in accordance with paragraph 606-10-55-65, the entity recognizes revenue for the sales-based royalty when those subsequent sales occur.

55-274 When License X is transferred, the entity recognizes as revenue the $800 allocated to License X.

Case B — Variable Consideration Allocated on the Basis of Standalone Selling Prices

55-275 The price stated in the contract for License X is a fixed amount of $300, and for License Y the consideration is 5 percent of the customer’s future sales of products that use License Y. The entity’s estimate of the sales-based royalties (that is, the variable consideration) is $1,500 in accordance with paragraph 606-10-32-8.

55-276 To allocate the transaction price, the entity applies the criteria in paragraph 606-10-32-40 to determine whether to allocate the variable consideration (that is, the sales-based royalties) entirely to License Y. In applying the criteria, the entity concludes that even though the variable payments relate specifically to an outcome from the performance obligation to transfer License Y (that is, the customer’s subsequent sales of products that use License Y), allocating the variable consideration entirely to License Y would be inconsistent with the principle for allocating the transaction price. Allocating $300 to License X and $1,500 to License Y does not reflect a reasonable allocation of the transaction price on the basis of the standalone selling prices of Licenses X and Y of $800 and $1,000, respectively. Consequently, the entity applies the general allocation requirements in paragraphs 606-10-32-31 through 32-35.

55-277 The entity allocates the transaction price of $300 to Licenses X and Y on the basis of relative standalone selling prices of $800 and $1,000, respectively. The entity also allocates the consideration related to the sales-based royalty on a relative standalone selling price basis. However, in accordance with paragraph 606-10-55-65, when an entity licenses intellectual property in which the consideration is in the form of a sales-based royalty, the entity cannot recognize revenue until the later of the following events: the subsequent sales occur or the performance obligation is satisfied (or partially satisfied).

55-278 License Y is transferred to the customer at the inception of the contract, and License X is transferred three months later. When License Y is transferred, the entity recognizes as revenue the $167 ($1,000 ÷ $1,800 × $300) allocated to License Y. When License X is transferred, the entity recognizes as revenue the $133 ($800 ÷ $1,800 × $300) allocated to License X.

55-279 In the first month, the royalty due from the customer’s first month of sales is $200. Consequently, in accordance with paragraph 606-10-55-65, the entity recognizes as revenue the $111 ($1,000 ÷ $1,800 × $200) allocated to License Y (which has been transferred to the customer and is therefore a satisfied performance obligation). The entity recognizes a contract liability for the $89 ($800 ÷ $1,800 × $200) allocated to License X. This is because although the subsequent sale by the entity’s customer has occurred, the performance obligation to which the royalty has been allocated has not been satisfied.

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.

The examples below illustrate possible approaches that may be appropriate when a licensing arrangement includes (1) fixed consideration and sales- or usage-based royalties and (2) more than one performance obligation.

Example 12-39

Entity X, a cable TV network company, enters into a four-year contract with Entity Y on January 1, 201X. The contract gives Y an exclusive license, including digital streaming rights (within specific territories), to a preexisting library of X’s historical content in addition to any new content that becomes available during the four-year term. Entity X determines that there are two distinct performance obligations in accordance with ASC 606-10-25-19 through 25-22 as follows:

A license of the preexisting library of content (i.e., the historical content) transferred to Y at the outset of the contract. Entity X determines that this is a right-to-use license of IP for which revenue is recognized at a point in time in accordance with ASC 606-10-55-63.
A license for any new content that is transferred to Y as it becomes available throughout the duration of the contract. Entity X determines that the obligation to update the license arrangement to include new content is a stand-ready obligation to provide updates to Y over the license term. Entity X concludes that it will satisfy this obligation ratably over the four-year license term.

Entity Y is required to pay X a royalty fee of $2 per subscriber per month over the contract term, subject to a minimum guaranteed amount of $10 million. Entity X estimates that over the contract term, it is probable that X will be entitled to total royalties of $30 million. In addition, X determines that (1) the stand-alone selling price of the license of historical content is $12 million (40 percent of the total estimated transaction price) and (2) the stand-alone selling price of the license of new content is $18 million (60 percent of the total estimated transaction price). The number of subscribers to Y’s service in year 1 is such that X is entitled to a royalty of $13 million.

Entity X determines that there are at least two acceptable approaches (“Approach A” and “Approach B”) to allocating the $10 million guaranteed minimum fee and the $2 per subscriber royalty fee between the two performance obligations in the contract.

Whichever approach is adopted, as discussed below, X will need to consider whether it is required to constrain the amount of revenue recognized in accordance with ASC 606-10-32-11 and apply the sales- or usage-based royalty exception in ASC 606-10-55-65.

Revenue Recognition Based on Initial Allocation of Fixed and Variable Consideration

Approach A

Under Approach A, X allocates both the fixed and variable consideration to each performance obligation on the basis of the relative stand-alone selling prices of the historical and new content as follows:

In year 1, X recognizes revenue as follows:

$4 million of the guaranteed minimum revenue allocated to the historical content is recognized upon the initial transfer of the historical content to Y.
$1.5 million of the guaranteed minimum revenue is allocated to and recognized for the new content ($6 million ÷ 4 years of license term).
The royalty payments received in excess of the $10 million guaranteed revenue are subject to the guidance in ASC 606-10-55-65 on recognizing revenue related to sales- or usage-based royalties. Therefore, $3 million ($13 million of royalties owed for year 1 less the $10 million of guaranteed minimum revenue) is allocated on a relative stand-alone selling price basis. Accordingly, $1.2 million is allocated to and recognized for the historical content, and $1.8 million is allocated to and recognized for the new content.

Thus, the total revenue recognized in year 1 under Approach A is $8.5 million, as illustrated in the table below.

Note that the royalties in excess of the guaranteed minimum that are allocated to the new content in year 1 ($1.8 million) do not need to be restricted in accordance with ASC 606-10-55-65 because the total revenue recognized for the new content ($3.3 million) is less than the amount corresponding to the measure of progress ($18 million ÷ 4 years of license term = $4.5 million).

Approach B

Under Approach B, X allocates the consideration on a first in, first out basis. Accordingly, the guaranteed minimum and estimated royalties are first allocated to the historical content and then to the new content, as illustrated in the table below. Note that the estimated royalties are subject to the constraint that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved (see Section 6.3.3 for further discussion of this objective).

In year 1, X recognizes revenue as follows:

$10 million of the guaranteed minimum allocated to the historical content is recognized upon the initial transfer of the historical content to Y.
$2 million of the variable consideration allocated to the historical content is recognized when the first $2 million of royalties earned in excess of the guaranteed $10 million becomes payable by Y.
While on a pro rata basis, X would recognize $4.5 million ($18 million ÷ 4 years of license term) with respect to the new content, X is able to recognize only $1 million with respect to the new content ($13 million of royalties owed for year 1 less the $12 million recognized with respect to the historical content) since the variable consideration is subject to the restriction in ASC 606-10-55-65 on recognizing revenue related to sales- or usage-based royalties.

Thus, the total revenue recognized in year 1 under Approach B is $13 million, as illustrated in the table below.

Revenue Recognition Based on Updated Allocation of Fixed and Variable Consideration

Each of the approaches discussed above is affected differently by a change in the estimate of royalties to which the entity expects to be entitled. The impact of any change in estimate under each approach should be carefully considered in accordance with the guidance on estimating and constraining variable consideration, whose objective is to include some or all of an amount of variable consideration estimated in the transaction price only to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved (see Section 6.3.3 for further discussion of this objective).

Suppose that after one year, X updates the transaction price in accordance with ASC 606-10-32-14 and concludes that it is probable that X will be entitled to total royalties of only $20 million over the four-year contract term as a result of changing market conditions (i.e., $10 million less than the original estimated transaction price). Under ASC 606-10-32-43, X is required to reallocate the transaction price to each performance obligation on the same basis as at contract inception. Also assume that in year 2, only $2 million in additional royalties is earned and payable to X (total consideration of $15 million has been earned to date, and there is an expectation that an additional $5 million will be received for the remaining contract term).

The effect of the updated expectations on revenue recognized in year 2 under each approach is discussed below.

Approach A

Under Approach A, X updates the allocation of the fixed and variable consideration to each performance obligation on the basis of the relative stand-alone selling prices of the historical and new content as follows:

Accordingly, revenue is recognized as follows:

Note that the royalties allocated to the new content ($3 million) are not restricted in accordance with ASC 606-10-55-65 because the total revenue recognized for new content ($6 million) does not exceed the amount corresponding to the measure of progress, or ($12 million ÷ 4 years of license term) × 2 years = $6 million.

Approach B

Under Approach B, X updates the allocation of the fixed and variable consideration to each performance obligation on the basis of the relative stand-alone selling prices of the historical and new content as follows:

As a result of the updated estimate of the transaction price, X is limited in recognizing additional revenue in year 2 when it reallocates the total expected consideration between the historical and new content. Revenue is recognized as follows:

Note that the royalties allocated to the new content ($5 million) are restricted under Approach B in accordance with ASC 606-10-55-65 because the total revenue otherwise recognized for the new content ($7 million) would exceed the amount corresponding to the measure of progress, or ($12 million ÷ 4 years of license term) × 2 years = $6 million. Consequently, $1 million of the royalties received in year 2 would need to be deferred.

As noted in the tables above, Approach A and Approach B have different accounting outcomes for both the consideration recognized as revenue in year 1 of the agreement and the changes in subsequent years to the estimated consideration to which X expects to be entitled. Care should be taken in the election of a policy, and careful evaluation of the objective behind constraining estimates of variable consideration should guide this election.

Example 12-40

Entity K, a biotechnology company, enters into a contract with Customer C to provide a license of functional IP as well as R&D services. As a result of the late stage of development of the IP and other factors, K has concluded that the license and R&D services are distinct performance obligations. The contract consideration includes (1) an up-front payment ($30 million), (2) royalties of 8 percent of future sales (estimated to be $50 million), and (3) a reimbursement for the R&D services at cost plus a fixed margin (estimated to be $20 million). Entity K has concluded that the license to IP is predominant in the arrangement.

Entity K has estimated the stand-alone selling prices of the performance obligations as follows:

Performance Obligation	Stand-Alone Selling Price
License	$ 80 million
R&D services	$ 20 million

Because the sales- or usage-based royalty exception is a recognition constraint (applied as part of step 5 of ASC 606’s revenue model), K could still consider the sales-based royalties in the estimated transaction price to be allocated even though they are subject to the sales- or usage-based royalty exception (and are constrained at contract inception). That is, K might reasonably conclude that it can allocate the royalties (estimated to be $50 million) together with the up-front fee of $30 million (a total expected amount of $80 million) entirely to the license since such allocation would be consistent with the stand-alone selling price of the license and, therefore, with the allocation objective in ASC 606-10-32-28 and ASC 606-10-32-40. Entity K could also allocate the $20 million to which it expects to be entitled for performing the R&D services entirely to the R&D services performance obligation. Such allocation would also be consistent with the allocation objective because the consideration to which K expects to be entitled as it performs the R&D services represents the stand-alone selling price for those services. The approach described herein is consistent with the approach illustrated in Example 35, Case A, of ASC 606.

As a result of the above allocations, K would recognize (1) revenue of $30 million when the license is transferred at contract inception ($80 million total consideration allocated to the license, of which $50 million is constrained because of the sales- or usage-based royalty exception) and (2) revenue for the R&D services at the contractual reimbursement rate as services are performed. Additional revenue related to the transfer of the license would be recognized as royalties become due (i.e., once sales associated with the licensed IP occur).

Example 12-41

Assume the same facts as in the previous example, except that the R&D services are reimbursed by Customer C at cost with no margin (estimated to be $15 million). Since Entity K would not typically provide R&D services on a stand-alone basis for cost (i.e., with no margin), use of the allocation approach described in the previous example would not result in an allocation that is consistent with the allocation objective in ASC 606-10-32-28 and ASC 606-10-32-40. Consequently, K would not be able to use the same approach in this situation.

If K continues to believe that the royalties are entirely related to the license, K could allocate the total expected transaction price ($95 million) to the performance obligations on a relative stand-alone selling price basis as follows:

Performance Obligation	Stand-Alone Selling Price	Relative Allocation	Allocation of Estimated Contract Consideration
License	$ 80 million	80%	$ 76 million
R&D services	$ 20 million	20%	$ 19 million
Total	$ 100 million	100%	$ 95 million

As the table illustrates, this approach would result in the allocation of $76 million to the license and $19 million to the R&D services. If K concludes that the royalties are entirely related to the license (i.e., the criteria in ASC 606-10-32-40 are met), it would recognize revenue of $26 million when the license is transferred at contract inception (the $76 million allocated transaction price less the $50 million that is constrained because of the sales- or usage-based royalty exception). Further, K would recognize (1) revenue of $19 million allocated to the R&D services as the R&D services are performed by using a single measure of progress and (2) additional revenue related to the transfer of the license as royalties become due (i.e., once sales associated with the licensed IP occur).

12.7.7 Applicability of the Sales- or Usage-Based Royalty Exception to Agents

The guidance in ASC 606-10-55-65 discusses situations in which an entity transfers a license of IP to a customer in exchange for a sales- or usage-based royalty. However, in some cases, an entity may be compensated in the form of a sales- or usage-based royalty for services that are directly related to a license of IP, but the entity itself is not licensing the IP because it is not the owner of the IP. The examples below illustrate situations in which an entity provides services in exchange for a sales- or usage-based royalty that is directly related to a license of IP.

Example 12-42

Company X, acting as a film distributor (agent), enters into arrangements to distribute filmed media content to theaters or other outlets (e.g., video on demand service providers) to make the content available for viewing by various audiences. The filmed content was produced and is owned by another entity (the “licensor”). In such arrangements, X acts as an agent between the licensor and the customer (e.g., a theater or another outlet). In exchange for performing the agency services, X is entitled to variable consideration based on the licensor’s royalties underlying the sales related to the licensed IP (e.g., ticket sales). The licensor’s earnings and, in turn, the fees earned by X are directly tied to the sales of the licensed IP.

Example 12-43

Company Y, acting as a talent agent, finds roles for its clients in films or other theatrical productions. Each of Y’s clients is paid a stated royalty percentage based on the sales or usage of the film or production (i.e., the IP), and Y’s commission is equal to a stated percentage of the royalty earned by the client. Company Y does not own or control the film or production at any point, and neither does Y’s client; rather, Y’s ability to generate commissions depends on how the film or production is monetized. Accordingly, the client’s earnings and, in turn, the commissions earned by Y are directly tied to the sales or usage of the licensed IP.

Example 12-44

Company Z, acting as an agent, identifies licensees to enter into contracts with Z’s clients (i.e., licensors). Each of Z’s clients is paid a stated royalty percentage based on the sales and usage of the IP licensed by the licensee (e.g., a college logo on merchandise), and Z’s commission is a stated percentage of the royalty earned by its client. Company Z does not own or control the IP at any point; rather, Z’s ability to generate commissions is dependent on the existence of its client’s IP. Accordingly, the client’s earnings and, in turn, the commissions earned by Z are directly tied to the sales or usage of the licensed IP.

In each of the examples above, the agent may account for the fees or commissions it earned in accordance with either of the following views, which are equally acceptable:

View 1 — The sales- or usage-based royalty exception in ASC 606-10-55-65 is applicable.
View 2 — The sales- or usage-based royalty exception in ASC 606-10-55-65 does not apply. Because the agent is not licensing IP on its own, it determines that the consideration it received was not in exchange for a license of IP; rather, the consideration was in exchange for the agency service it promised to perform under the contract. Therefore, the agent concludes that it should apply the variable consideration guidance in ASC 606-10-32-5 through 32-14, including the guidance on constraining estimates of variable consideration (see Section 6.3.3).

Generally, the sales- or usage-based royalty exception may be applied only in limited situations by the licensor (i.e., when an entity licenses its IP and is compensated in the form of a royalty that varies on the basis of the customer’s sales or usage of the licensed IP). However, there are situations in which an entity may apply the sales- or usage-based royalty exception even though it does not own the IP or act as the principal in the arrangement (i.e., it does not control or license the IP). When determining whether it is appropriate to apply the sales- or usage-based royalty exception in these situations, entities should consider the nature of the services being provided to the customer and use judgment to determine whether such services are directly related to the IP that is being licensed. That is, if the revenue to be received is based on a sales- or usage-based royalty from a license of IP and the service provided by the entity is directly related to that IP, it would be acceptable to apply the royalty exception in ASC 606-10-55-65.

This conclusion is consistent with the discussion in paragraph BC415 of ASU 2014-09, which explains that if the exception did not apply, an entity would be required to “report, throughout the life of the contract, significant adjustments to the amount of revenue recognized at inception of the contract as a result of changes in circumstances, even though those changes in circumstances are not related to the entity’s performance.” On the basis of discussion with the FASB staff, we understand that the Board did not intend to limit the exception to owners of the IP (i.e., the logic for providing the exception would apply equally to the owners of the IP and others receiving a portion of a royalty for services directly related to the license of the IP).

If the services being provided are not directly linked to the underlying IP being licensed or the entity’s compensation does not vary on the basis of the sales or usage of the licensed IP, it would not be appropriate to apply the sales- or usage-based royalty exception.

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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.