Chapter 12 — Licensing
Chapter 12 — Licensing
12.1 Overview
Under the revenue standard, the framework used to account for licensing of
intellectual property (IP) is essentially the same as the framework used to account
for a sale of goods or services. That is, the five-step model is generally applied
to licensing transactions as well. However, licensing of IP can take many forms, and
the economics and substance of such transactions can often be difficult to identify.
Determining how to account for licensing transactions will often depend on the
specific facts and circumstances and will require professional judgment. To help
preparers exercise such judgment, the revenue standard provides supplemental
guidance on recognizing revenue from contracts related to the licensing of IP to
customers. The scope of the guidance includes all licenses that provide a customer
with rights to IP, except for certain software hosting arrangements that are
accounted for as a service (see Section
12.2.1).
In the evaluation of how to account for a licensing transaction under the
revenue standard, it is important for an entity to consider each of the five steps
in the model (although, as discussed below, certain exceptions are provided for
licensing transactions). Specifically, an entity will need to do each of the
following:
-
Step 1: Identify the contract with the customer — This step includes identifying the counterparty that is the customer, evaluating the enforceable rights and obligations (including implicit rights) of each party to the contract, and determining whether amounts under the contract are collectible.1
-
Step 2: Identify the performance obligations under the contract — This includes determining whether the entity’s obligation to transfer a license to a customer results in (1) a single promise that will be satisfied (i.e., a single performance obligation) or (2) multiple performance obligations. This step could also involve determining whether the license of IP is the predominant element in the arrangement.
-
Step 3: Determine the transaction price — This includes identifying and, potentially, measuring and constraining variable consideration.
-
Step 4: Allocate the transaction price— This includes considering whether the residual approach could be used for determining the stand-alone selling price of one (or a bundle) of the performance obligations.2
-
Step 5: Determining when control of the license is transferred to the customer — This includes determining whether the license is transferred at a point in time (for a right to use IP) or over time (for a right to access IP).
Some of the key judgments an entity will need to make are likely to be in
connection with step 2 (identify the performance obligations), step 4 (allocate the
transaction price), and step 5 (recognize revenue) of the model. As part of step 2,
an entity will need to evaluate license restrictions (and changes in any such
restrictions) when determining whether the restrictions merely define the licenses
(which may be the case when the restrictions are related to time or geography) or,
in effect, give rise to multiple performance obligations (which may be the case when
the restrictions change over the license period and require the entity to transfer
additional rights to the customer).
As part of step 5, when an entity is determining whether it has granted a
customer a right to use or a right to access its IP, it will need to assess the
nature of the promised license to determine whether the license has significant
stand-alone functionality. For licenses with significant stand-alone functionality,
ongoing activities3 of the entity providing the license do not significantly affect the license’s
functionality (i.e., its utility). However, certain licenses do not have significant
stand-alone functionality and require ongoing activities from the entity to support
or maintain the license’s utility to the customer. The nature of an entity’s license
of IP will determine the pattern of transfer of control to the customer, which is
either at a point in time (if the customer is granted a right to use the IP) or over
time (if the customer is granted a right to access the IP).
For licensing transactions in which consideration is tied to the subsequent sale
or usage of IP, the revenue standard provides an exception to the recognition
principle that is part of step 5 (i.e., recognize revenue when or as control of the
goods or services is transferred to the customer). Under this sales- or usage-based
royalty exception, an entity would generally not be required to estimate the
variable consideration from sales- or usage-based royalties. Instead, the entity
would wait until the subsequent sale or usage occurs to determine the amount of
revenue to recognize.
As a result of implementation concerns raised by various stakeholders after the
issuance of ASU
2014-09, the TRG discussed several licensing issues. After
debating these issues, the TRG requested that the FASB issue clarifying guidance to
help stakeholders apply the revenue standard to licensing arrangements. In April
2016, the FASB issued ASU
2016-10, which was intended to improve the operability and
understandability of the standard’s licensing guidance on (1) determining the nature
of the arrangement, (2) applying the sales- or usage-based royalty constraint, and
(3) clarifying how contractual provisions affect licenses of IP.
Footnotes
1
Refer to Section 4.4.1 for (1)
guidance on determining the contract term for certain licensing
arrangements and (2) a discussion of challenges associated with
applying the revenue standard to licensing arrangements that
involve termination rights.
2
Refer to Section
7.3.3.7 for more information about estimating
stand-alone selling prices for term licenses and postcontract
customer support and Section 7.3.3.2 for more
information about the residual approach to estimating
stand-alone selling prices and allocating the transaction price
when a value relationship exists.
3
These do not include activities that transfer one or more
goods or services to the customer (e.g., maintenance activities), which an
entity must assess to determine whether they constitute separate performance
obligations.
12.2 Scope of the Licensing Guidance
ASC 606-10
55-54 A license establishes a
customer’s rights to the intellectual property of an entity.
Licenses of intellectual property may include, but are not
limited to, licenses of any of the following:
-
Software (other than software subject to a hosting arrangement that does not meet the criteria in paragraph 985-20-15-5) and technology
-
Motion pictures, music, and other forms of media and entertainment
-
Franchises
-
Patents, trademarks, and copyrights.
Although the guidance above provides examples of licenses of IP, the
term “intellectual property” is not formally defined in U.S. GAAP. However,
paragraph BC51 of ASU 2016-10 states that “intellectual property is inherently
different from other goods or services because of its uniquely divisible nature,”
noting that “intellectual property can be licensed to multiple customers at the same
time . . . and can continue to be used by the entity during the license period for
its own benefit.” Identification of IP will require judgment.
Connecting the Dots
The licensing guidance in the revenue standard applies to
licenses of IP that are an output of an entity’s ordinary activities (and,
therefore, contracts to provide licenses of IP to customers). In some
instances, an entity whose ordinary activities do not involve the licensing
of IP may enter into a contract to provide a license of IP to a third party.
Because the contract is not with a customer, the licensing guidance in the
revenue standard is not directly applicable. Further, because a
derecognition event does not occur in a licensing transaction (i.e., there
is no sale of the IP itself), the guidance in ASC 610-20 on accounting for
gains and losses on the derecognition of nonfinancial assets is also not
directly applicable. That is, a license of IP is outside the scope of ASC
610-20 since the license does not result in the transfer of the underlying
IP when the entity still controls the IP (see Section 12.2.2 for more information
about distinguishing between a license and an in-substance sale of IP).
We believe that an entity could apply the licensing guidance
in the revenue standard by analogy to account for the measurement and
recognition of licenses of IP that are outside the scope of ASC 606 (i.e.,
licenses of IP that are not an output of the entity’s ordinary activities).
For example, an entity could apply ASC 606 to determine whether a license of
IP to a noncustomer represents a license to functional or symbolic IP. In
addition, a license of IP to a noncustomer could include sales- or
usage-based royalties, in which case an entity could apply the sales- or
usage-based royalty exception in ASC 606. However, while an entity could
apply aspects of ASC 606 by analogy, any gain or loss should not be
presented or disclosed as revenue from contracts with customers.
If an entity entered into an agreement with a noncustomer to
sell the underlying IP instead of licensing the IP (i.e., the entity
transferred control of the IP and derecognized it), the sale would be within
the scope of ASC 610-20. In that case, the sales- or usage-based royalty
exception would not apply (because the exception applies only to
licenses of IP). Rather, the entity would need to estimate and
constrain royalties when determining the gain or loss it should record on
the transfer of control of the IP.
12.2.1 Software in a Hosting Arrangement
Software in a hosting arrangement is excluded from the scope of
the licensing guidance in the revenue standard unless both of the following
criteria in ASC 985-20-15-5 are met:
-
The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty.
-
It is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.
Connecting the Dots
Some may question whether “at any time” during the hosting period means
at every point in time during the hosting period. We do not
believe that to be the case. For example, an entity’s arrangements may
specify that the customer will automatically obtain the software at the
end of the hosting period. We believe that as long as the customer can
take possession of the software at that point without significant
penalty and it is feasible for the customer to run the software (either
on its own or with a third-party vendor), the software license is a
separate promise in the hosting arrangement and would therefore meet the
criteria in ASC 985-20-15-5(a) and (b).
Many software hosting arrangements include a “license” to
software but allow the customer to use the software only in the entity’s (rather
than the customer’s) hosted environment (because of contractual or practical
limitations, or both). Although these arrangements may include a contractual
license, since the customer is unable to take possession of the software subject
to the license without significant penalty, the customer is required to make a
separate buying decision before control of any software is truly transferred to
the customer (the separate buying decision would be the customer’s election to
incur the penalty to take possession of the software). These transactions are
accounted for as service transactions (rather than licensing transactions) since
the entity is providing the functionality of the software through a hosting
arrangement (service) rather than through an actual software license that is
controlled by the customer.
Connecting the Dots
It is common for software to be hosted on the platform
or infrastructure of a third party rather than that of the vendor or
customer. In these circumstances, it is important to determine who has
the contract with the third party (i.e., whether it is the vendor’s or
customer’s cloud instance4 of the third-party platform or infrastructure). If the software is
hosted on the customer’s cloud instance, the customer has possession of
the software, and the arrangement would be subject to the licensing
guidance in the revenue standard. By contrast, if the software is hosted
on the vendor’s cloud instance and the customer cannot otherwise obtain
possession of the software without significant penalty, the software is
provided in a hosting arrangement and is excluded from the licensing
guidance in the revenue standard.
Example 12-1
Entity L, a software vendor, offers its
office productivity package in an online format whereby
a user accesses a Web site and stores files on a secure
server. The applications will always be maintained at
the most up-to-date version available, and customers
have rights to online and telephone support. The
customer will pay a fee of $200 for a one-year “right to
use” license for software. Renewal fees are $200 for
each subsequent year renewed. The customer does not have
the ability to take possession of the software.
The license cannot be unbundled from the
hosting service because the customer is not permitted to
take possession and may only use the software together
with L’s hosting service. Therefore, the criteria in ASC
985-20-15-5 are not met, and the arrangement
consequently does not contain a license as described in
ASC 606-10-55-54. Entity L should recognize the $200
over the one-year term of the arrangement once the
customer has access to the hosted software.
As noted above, to determine whether a right to use software in
a hosted environment includes a license within the scope of the revenue
standard’s licensing guidance, entities need to consider whether the software
license is within the scope of ASC 985-20. For the software subject to a hosting
arrangement to be within the scope of ASC 985-20 (and, therefore, within the
scope of the licensing guidance in the revenue standard), the criteria in ASC
985-20-15-5(a) and (b) must both be met.
ASC 985-20-15-6 states that the term “significant penalty” as used in ASC
985-20-15-5(a) contains the following two distinct concepts:
- The ability to take delivery of the software without incurring significant cost
- The ability to use the software separately without a significant diminution in utility or value.
The analysis for determining whether a significant penalty exists depends on the
facts and circumstances of the arrangement and requires judgment. An entity may
consider the following factors (not all-inclusive) in making this assessment:
- Contractual cancellation fees associated with the hosting arrangement.
- Other contractual penalties for taking possession of the software (e.g., the requirement that the customer continue to pay the hosting fees for the remainder of the hosting term even though hosting services are terminated).
- Costs of transitioning to (1) use of the software on the customer’s own servers or (2) hosting of the software by the customer’s third-party vendor.
- Whether the utility and value of the software can be maintained upon transition (e.g., whether (1) the customer will continue to receive updates, upgrades, and enhancements and (2) the software will be capable of providing the same functionality in another environment).
- Whether the software (1) has stand-alone functionality (on its own or with readily available resources) or (2) is significantly tied to other products or services that can be provided only by the entity and will no longer be provided if the customer takes possession of the software.
Significance can be evaluated both quantitatively and qualitatively. The
accounting literature does not contain specific guidance on (1) which elements
of the contract should be included in the measurement of the amount of the
penalty or (2) the benchmark against which the entity should measure the amount
of the penalty when determining whether the penalty is quantitatively
significant. An entity may have an established policy for determining whether
the penalty is significant. For example, in a manner consistent with other
Codification subtopics, the entity may reasonably conclude that amounts above 10
percent of a given benchmark are significant. Establishing a method of
determining both the elements of the contract to include in the measurement of
the penalty and the benchmark against which to measure the penalty is an
accounting policy decision that the entity should apply consistently.
Example 12-2
Company E is developing a customer
relationship management (CRM) software solution to be
marketed and sold to customers. The software will be
provided to customers on a hosted basis (i.e., the
software will be accessed by using an Internet
connection) and will connect to E’s proprietary data
analytics platform, which has already been developed and
is housed on E’s own servers (i.e., it is a software as
a service [SaaS] solution that is accessed only online).
Company E’s data analytics platform will be a
significant part of the overall solution sold to its
customers and will be significantly integrated with the
CRM software solution being developed. Company E plans
to provide its customers with the contractual ability to
take possession of the CRM software on an on-premise
basis, when requested at any point during the hosting
period, without paying E a penalty or cancellation fee.
However, customers will not have the contractual ability
to take possession of E’s data analytics platform. In
addition, cancellation of the hosting service for the
CRM software will also result in the cancellation of the
SaaS for E’s data analytics platform, which cannot be
easily replicated by the customer or third-party
vendors. Further, customers would incur significant
costs to integrate the CRM software with other
third-party data analytics platforms.
While a customer will have “the
contractual right to take possession of the software at
any time during the hosting period” without paying E a
penalty or cancellation fee, it cannot do so without
incurring a significant penalty (i.e., significant
diminution in utility or value of the CRM software
without E’s data analytics platform). Therefore, E
concludes that arrangements with customers for the CRM
software solution do not meet the criteria to be
accounted for as licensing arrangements.
12.2.2 License Versus In-Substance Sale of IP
Other scope-related questions may require judgment. For example,
stakeholders have raised concerns regarding the evaluation of whether certain
licensing arrangements that are in-substance sales of IP should be accounted for
as sales of IP (under either the guidance in ASC 606 unrelated to licenses if
the sales arise from contracts with customers [see Chapter 4] or the guidance in ASC 610-20
on sales of nonfinancial assets if the sales are transactions with noncustomers
[see Chapter 17])
or as licenses of IP. For example, an entity may license IP to a customer under
an arrangement that gives the customer exclusive use of the IP for either a
perpetual term or a period that is substantially the same as the IP’s useful
life.
Stakeholders have questioned whether these arrangements would be
within the scope of (1) the licensing implementation guidance discussed in this
chapter or (2) the general recognition and measurement model in the revenue
standard, which could result in a different pattern of revenue recognition.
Specifically, concerns have been raised about the application of the sales- or
usage-based royalty exception (see Section 12.7). The FASB considered, but
rejected, expanding the scope of the royalty recognition constraint because of
complexities in legal differences between a sale of IP and a license of IP. More
specifically, the FASB noted in the Background Information and Basis for
Conclusions of ASU 2016-10 that an entity should not distinguish between
licenses and in-substance sales in deciding whether the royalty exception
applies. We generally believe that the legal form of the transaction will
determine which revenue accounting guidance (i.e., the guidance on estimating
royalties or the guidance on applying the royalty recognition constraint) is
applicable. For discussion of the scope of the sales- or usage-based royalty
exception, see Section
12.7.3.
12.2.3 Sales of Books, Recorded Music, and Similar Items
In many industries, it is common for an entity to sell a
tangible product (e.g., a DVD, CD, or hard-copy book) that contains IP such as a
movie, music, or a novel (a “copyrighted work”).
The “first sale doctrine”5 provides that an individual who purchases a copy of a copyrighted work
from the copyright holder is the owner of that individual copy and receives the
right to sell, lease, or otherwise dispose of that particular copy without the
permission of the copyright owner. Therefore, the owner of an individual copy of
IP controls the economic benefits of that copy of the copyrighted work. However,
the owner of the copy has no right to the underlying copyright in the work and
has only purchased use of that specific instance of the copyrighted work. While
the term “first sale doctrine” is specific to U.S. law, many other jurisdictions
have similar regulations related to copyrighted work.
An entity should not apply the implementation guidance on
licenses in ASC 606-10-55-54 through 55-65B to sales of goods subject to the
first sale doctrine or other similar jurisdictional regulations. Rather, such
transactions should be considered sales of goods rather than licenses of IP.
Although there is a license to the IP incorporated in the good,
the contract with the customer is an arrangement for the sale of a good (e.g., a
single, physical copy of a book) rather than the IP. That is, sales of goods
subject to the first sale doctrine should be evaluated as sales of tangible
goods rather than licenses of IP since the original purchaser of the goods
relinquishes all rights to the underlying IP if it sells or otherwise transfers
the associated goods to another party. As a result, the general guidance in ASC
606 should be applied to such sales in the same way it is applied to other sales
of goods.
In instances in which the entity also promises to provide the
customer with the right to download a digital copy of the IP (e.g., a movie or
song) that may be installed on a mobile device and this digital copy is subject
to certain restrictive licensing terms and conditions that result in the
inability to transfer the downloaded content to another party (i.e., the digital
copy is not subject to the first sale doctrine), the entity should assess
whether the promise to provide the download right is distinct. If the promise is
distinct, the entity should apply the implementation guidance on licenses in ASC
606-10-55-58 through 55-65B.
Footnotes
4
When used in the context of cloud capacity, the
term “cloud instance” refers to the cloud environment in which
the software operates.
5
The first sale doctrine, codified in 17 U.S.C. Section
109, provides that an individual who knowingly purchases a copy of a
copyrighted work from the copyright holder receives the right to sell,
display, or otherwise dispose of that particular copy notwithstanding
the interests of the copyright owner. However, the right to distribute
ends once the owner has sold that particular copy (see 17 U.S.C.
Sections 109(a) and 109(c)). Since the first sale doctrine never
protects a defendant who makes unauthorized reproductions of a
copyrighted work, the first sale doctrine cannot be a successful defense
in cases that allege infringing reproduction. Further, 17 U.S.C. Section
109(d) provides that the privileges created by the first sale principle
do not “extend to any person who has acquired possession of the copy or
phonorecord from the copyright owner, by rental, lease, loan, or
otherwise, without acquiring ownership of it.” Most computer software is
distributed through the use of licensing agreements. Under this
distribution system, the copyright holder remains the “owner” of all
distributed copies. For this reason, alleged infringers should not be
able to establish that any copies of these works have been the subject
of a first sale. That is, sales of software will typically not be
subject to the first sale doctrine.
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
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 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 the license is
predominant 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.
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.
12.3.3.4 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
6
Cases A and B of Example 10, on
which Case C is based, are reproduced in Section
5.3.2.3.
7
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.
8
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 (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.”
12.4 Identifying the Nature of the License
In developing the revenue standard, the FASB and IASB committed to
developing a single, comprehensive framework to apply to all types of
revenue-generating transactions, including licenses of IP.9
As discussed in paragraph BC403 of ASU 2014-09, applying a single
framework to licenses of IP proved to be challenging because “licenses vary
significantly and include a wide array of different features and economic
characteristics, which lead to significant differences in the rights provided by a
license.” The boards acknowledged that in some situations, a customer may be unable
to control the license at the time of transfer because of the nature of the
underlying IP and the entity’s potential continuing involvement with the IP.
However, this is not always the case. Therefore, the boards recognized that in a
manner consistent with the standard’s general revenue recognition model, control of
some licenses may be transferred at a point in time while control of other licenses
may be transferred over time.
ASC
606-10
55-58 In
evaluating whether a license transfers to a customer at a
point in time or over time, an entity should consider
whether the nature of the entity’s promise in granting the
license to a customer is to provide the customer with
either:
- A right to access the entity’s intellectual property throughout the license period (or its remaining economic life, if shorter)
- A right to use the entity’s intellectual property as it exists at the point in time at which the license is granted.
55-58A An
entity should account for a promise to provide a customer
with a right to access the entity’s intellectual property as
a performance obligation satisfied over time because the
customer will simultaneously receive and consume the benefit
from the entity’s performance of providing access to its
intellectual property as the performance occurs (see
paragraph 606-10-25-27(a)). An entity should apply
paragraphs 606-10-25-31 through 25-37 to select an
appropriate method to measure its progress toward complete
satisfaction of that performance obligation to provide
access to its intellectual property.
55-58B An
entity’s promise to provide a customer with the right to use
its intellectual property is satisfied at a point in time.
The entity should apply paragraph 606-10-25-30 to determine
the point in time at which the license transfers to the
customer.
In determining whether to recognize revenue from a license of IP
over time or at a point in time, an entity needs to determine the nature of the
licensing arrangement. The nature of the arrangement is determined on the basis of
the entity’s promise to the customer and whether that promise (1) provides access to
the IP throughout the license term (i.e., “right to access”) or (2) provides a right
to use the IP as it exists at the point in time when control of the license is
transferred to the customer (i.e., “right to use”). Revenue from a license that
grants a right to access an entity’s IP is recognized over time since the customer
simultaneously receives and consumes the benefits of the entity’s IP throughout the
license periods (i.e., meets the requirement in ASC 606-10-25-27(a)). Revenue from a
license that grants a right to use an entity’s IP is recognized at the point in time
when control of the license is transferred to the customer. An entity’s
determination of when control of a license has been transferred to a customer should
be based, in part, on the indicators in ASC 606-10-25-30. However, control of a
license cannot be transferred to a customer before the customer is able to use and
benefit from the license (i.e., the license term has commenced). For further
discussion, see Section 12.5.
To help an entity determine whether a license is a right to access
or right to use the entity’s IP, the revenue standard provides guidance on assessing
the nature of a license of IP. An entity’s ongoing activities, or lack of
activities, may significantly affect the utility of the license (i.e., the
functionality or value of the IP to the customer). These activities may be
explicitly or implicitly promised by the entity and may include supporting or
maintaining its IP for the duration of the customer’s license period. Further, the
obligation to maintain or support the IP may need to be identified as a separate
promise under the contract (insofar as the activities transfer additional goods or
services to the customer). To assist in the evaluation of whether the license
provides the customer with a right to access or right to use the entity’s IP, the
revenue standard distinguishes between two types of IP: (1) functional and (2)
symbolic.
ASC
606-10
55-59 To determine whether the
entity’s promise [is] to provide a right to access its
intellectual property or a right to use its intellectual
property, the entity should consider the nature of the
intellectual property to which the customer will have
rights. Intellectual property is either:
-
Functional intellectual property. Intellectual property that has significant standalone functionality(for example, the ability to process a transaction, perform a function or task, or be played or aired). Functional intellectual property derives a substantial portion of its utility (that is, its ability to provide benefit or value) from its significant standalone functionality.
-
Symbolic intellectual property. Intellectual property that is not functional intellectual property (that is, intellectual property that does not have significant standalone functionality). Because symbolic intellectual property does not have significant standalone functionality, substantially all of the utility of symbolic intellectual property is derived from its association with the entity’s past or ongoing activities, including its ordinary business activities.
In the original guidance issued in ASU 2014-09, the FASB and IASB
decided that the determination of whether a license grants the customer a right to
access or right to use the entity’s IP should hinge on whether the licensor’s
ongoing activities are expected to significantly affect the underlying IP.
Stakeholders identified significant implementation questions, which focused mainly
on (1) the nature of the licensor’s activities that affect the IP and (2) how
entities should evaluate the impact of such activities on the IP (e.g., the effect
on the IP’s form and functionality, value, or both). Those questions were discussed
by the TRG, and the TRG acknowledged that different interpretations may arise
between what constitutes a right-to-access and a right-to-use license. As a result,
the FASB decided to clarify the guidance on identifying the nature of a license. As
indicated in ASC 606-10-55-59 (as amended by ASU 2016-10), the Board decided that the
assessment of whether a license provides the customer with a right to access or a
right to use the entity’s IP should be based on whether the underlying IP is
functional or symbolic. Refer to Sections 12.4.1 and 12.4.2 for additional information on
functional and symbolic IP.
Connecting the Dots
In some instances, identifying the nature of a license is
straightforward and the outcome of whether the license provides the customer
with a right to access or a right to use the entity’s IP is readily
apparent. However, in other situations, this assessment is more complicated
and requires significant consideration and judgment. Specifically, this may
be the case when the entity promises to provide multiple nonlicense goods
and services in addition to the license, or when the license is subject to
various restrictions. As discussed above, there are many factors that
influence the recognition of revenue from a license of IP. Therefore, it
would not be appropriate to assume that certain types of licenses should
always be accounted for in a similar manner.
12.4.1 Functional IP
IP may have significant stand-alone functionality. For example,
some IP can be aired or viewed (e.g., a song or a movie) or can perform a task.
The functionality (i.e., ongoing utility) of this IP is not affected by the
entity’s activities (or lack of activities) that do not transfer an additional
good or service to the customer. That is, the customer controls the
functionality provided by the license to IP when control of the IP is
transferred to the customer. Any activities the entity undertakes to maintain or
enhance the IP are likely to be identified as a separate promise under the
contract. A license in these circumstances can be referred to as a license to
functional IP. Examples of licenses to functional IP could include software,
drug compounds and formulas, and completed media content (such as films,
television shows, or music).
ASC
606-10
55-62 A license to functional
intellectual property grants a right to use the entity’s
intellectual property as it exists at the point in time
at which the license is granted unless both of the
following criteria are met:
- The functionality of the intellectual property to which the customer has rights is expected to substantively change during the license period as a result of activities of the entity that do not transfer a promised good or service to the customer (see paragraphs 606-10-25-16 through 25-18). Additional promised goods or services (for example, intellectual property upgrade rights or rights to use or access additional intellectual property) are not considered in assessing this criterion.
- The customer is contractually or practically required to use the updated intellectual property resulting from the activities in criterion (a).
If both of those criteria
are met, then the license grants a right to access the
entity’s intellectual property.
55-63 Because functional
intellectual property has significant standalone
functionality, an entity’s activities that do not
substantively change that functionality do not
significantly affect the utility of the intellectual
property to which the customer has rights. Therefore,
the entity’s promise to the customer in granting a
license to functional intellectual property does not
include supporting or maintaining the intellectual
property. Consequently, if a license to functional
intellectual property is a separate performance
obligation (see paragraph 606-10-55-55) and does not
meet the criteria in paragraph 606-10-55-62, it is
satisfied at a point in time (see paragraphs
606-10-55-58B through 55-58C).
Generally, the nature of a license to functional IP that is
distinct will provide a customer with the right to use an entity’s IP (i.e.,
point-in-time revenue recognition) unless (1) the entity’s ongoing activities
that will not transfer promised goods to the customer (i.e., those not deemed to
be additional promised goods to the customer) will significantly change the
utility of the license and (2) the customer is contractually or practically
required to use the updated IP once available. If these criteria are met, the
nature of the license is a right to access the entity’s IP (i.e., a license for
which revenue is recognized over time). As discussed in paragraph BC58 of ASU
2016-10, the FASB expected that at the time of issuance of ASU 2016-10, the
criteria in ASC 606-10-55-62 “will be met only infrequently, if at all.” That is
because additional goods or services provided to the customer (e.g., updates and
customization services) are typically promised goods or services that would not
meet the criterion in ASC 606-10-55-62(a).
The following examples in ASC 606 illustrate the identification of functional
IP:
ASC
606-10
Example 54 — Right to Use Intellectual Property
55-362 Using the same facts
as in Case A in Example 11 (see paragraphs 606-10-55-141
through 55-145), the entity identifies four performance
obligations in a contract:
- The software license
- Installation services
- Software updates
- Technical support.
55-363 The entity assesses
the nature of its promise to transfer the software
license. The entity first concludes that the software to
which the customer obtains rights as a result of the
license is functional intellectual property. This is
because the software has significant standalone
functionality from which the customer can derive
substantial benefit regardless of the entity’s ongoing
business activities.
55-363A The entity further
concludes that while the functionality of the underlying
software is expected to change during the license period
as a result of the entity’s continued development
efforts, the functionality of the software to which the
customer has rights (that is, the customer’s instance of
the software) will change only as a result of the
entity’s promise to provide when-and-if available
software updates. Because the entity’s promise to
provide software updates represents an additional
promised service in the contract, the entity’s
activities to fulfill that promised service are not
considered in evaluating the criteria in paragraph
606-10-55-62. The entity further notes that the customer
has the right to install, or not install, software
updates when they are provided such that the criterion
in 606-10-55-62(b) would not be met even if the entity’s
activities to develop and provide software updates had
met the criterion in paragraph
606-10-55-62(a).
55-363B Therefore, the entity
concludes that it has provided the customer with a right
to use its software as it exists at the point in time
the license is granted and the entity accounts for the
software license performance obligation as a performance
obligation satisfied at a point in time. The entity
recognizes revenue on the software license performance
obligation in accordance with paragraphs 606-10-55-58B
through 55-58C.
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 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.
55-373 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.
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.
55-391 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.
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 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.
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.
Generally, the nature of a license to functional IP that is
distinct will provide an entity’s customer with the right to use the entity’s
IP, which results in the entity’s recognition of revenue at the point in time at
which control of the license is transferred to the customer. However, there are
situations in which an entity grants a license to functional IP that is
transferred at contract inception but also promises to provide ongoing services
that are not distinct from the license (i.e., the license and ongoing services
are combined into a single performance obligation).
It is not acceptable for an entity to recognize revenue at the point in
time at which a license to functional IP is granted when the revenue is related
to a single performance obligation to (1) grant the license and (2) perform
ongoing substantive services that are not distinct from the license. ASC
606-10-55-57 states:
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.
Although a license to functional IP provides the customer with a
right to use the entity’s IP as it exists at a point in time, the presence of an
ongoing substantive service that is not distinct from the license indicates that
the customer cannot continue to benefit from the license without the ongoing
service. In addition, the entity’s performance obligation is not fully satisfied
upon transfer of the license because the entity has promised to provide an
ongoing substantive service that is not separable from the license. That is, the
license to the functional IP and the ongoing service are inputs into a combined
item. Therefore, the nature of the entity’s performance obligation involves
continuing to provide the customer with an ongoing service over time. Because
the entity does not fully satisfy its performance obligation upon transferring
the license to the customer, it is not appropriate to recognize revenue for the
single performance obligation at that point in time.
12.4.2 Symbolic IP
Some forms of IP may not have stand-alone functionality when
transferred to a customer. The utility of these forms of IP is significantly
derived from the entity’s past or ongoing activities undertaken to maintain or
support the IP, and such activities do not transfer additional goods or services
to the customer. That is, the value of the IP is largely dependent on the
entity’s ongoing support or maintenance of that IP. In addition, the customer is
contractually or practically required to use the updated IP. Licenses to IP
whose value is derived from an entity’s ongoing activities may include brands,
teams, trade names, logos, and franchise rights. For example, a license to a
sports team’s name is directly affected by the team’s performance and its
continued association with the league in which it plays. If the team ceases to
play games, the value of the IP would most likely decline significantly.
Further, a customer could not choose to use the form of the IP that existed when
the team was still playing games. Rather, the customer has to use the most
current form of the IP. These types of IP are referred to as symbolic IP.
ASC 606-10
55-60 A customer’s ability to
derive benefit from a license to symbolic intellectual
property depends on the entity continuing to support or
maintain the intellectual property. Therefore, a license
to symbolic intellectual property grants the customer a
right to access the entity’s intellectual property,
which is satisfied over time (see paragraphs
606-10-55-58A and 606-10-55-58C) as the entity fulfills
its promise to both:
-
Grant the customer rights to use and benefit from the entity’s intellectual property
-
Support or maintain the intellectual property. An entity generally supports or maintains symbolic intellectual property by continuing to undertake those activities from which the utility of the intellectual property is derived and/or refraining from activities or other actions that would significantly degrade the utility of the intellectual property.
-
Subparagraph superseded by Accounting Standards Update No. 2016-10.
A symbolic license contains the characteristics of a
right-to-access license (i.e., a license for which revenue is recognized over
time) since the customer is simultaneously receiving the IP and benefiting from
it throughout the license period. An entity’s ongoing activities (including
actions that would significantly degrade the IP’s utility) will continue to
support or maintain (or significantly degrade) the IP’s utility to the
customer.
Connecting the Dots
As noted in paragraphs BC62 through BC65 of ASU 2016-10,
ASC 606 contains no guidance requiring the entity to promise or expect
to provide ongoing activities to maintain or support the IP. That is, if
the customer has acquired a license to symbolic IP, the license is a
right to access IP regardless of whether the entity expects to undertake
activities to maintain the IP. An example of this may be the right to a
license to a retired sports team’s name or logo. By contrast, under IFRS
15, an entity’s determination of whether a license is a right-to-use
rather than a right-to-access license is based on whether the underlying
IP is significantly affected by the entity’s ongoing activities. While
this is a difference between U.S. GAAP and IFRS Accounting Standards,
the FASB decided that the amendments in ASU 2016-10 would improve the
operability of the licensing guidance. For more discussion on
differences between U.S. GAAP and IFRS Accounting Standards, refer to
Appendix
A.
As noted in paragraph BC72 of ASU 2016-10, many right-to-access licenses “may
constitute a series of distinct goods or services that are substantially the
same and have the same pattern of transfer to the customer in accordance with
paragraph 606-10-25-14(b) (for example, a series of distinct periods [month,
quarter, year] of access).” See Section 5.3.3 for a discussion about the application of the
series guidance.
A right-to-access license is transferred to the customer (and thus, revenue is
recognized) over the shorter of the contractual term or the remaining economic
life of the IP. Therefore, if an entity provides a customer with a perpetual
license to symbolic IP, the entity will need to estimate the remaining economic
life of the IP to determine the appropriate period over which to recognize
revenue.
The following examples in ASC 606 illustrate the identification of symbolic IP:
ASC 606-10
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.
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.
Example 58 — Access to Intellectual
Property
55-383 An entity, a creator
of comic strips, licenses the use of the images and
names of its comic strip characters in three of its
comic strips to a customer for a four-year term. There
are main characters involved in each of the comic
strips. However, newly created characters appear and
disappear regularly and the images of the characters
evolve over time. The customer, an operator of cruise
ships, can use the entity’s characters in various ways,
such as in shows or parades, within reasonable
guidelines.
55-384 In exchange for
granting the license, the entity receives a fixed
payment of $1 million in each year of the 4-year
term.
55-385 The entity concludes
that it has made no other promises to the customer other
than the promise to grant a license. That is, the
additional activities associated with the license do not
directly transfer a good or service to the customer.
Therefore, the entity concludes that its only
performance obligation is to transfer the license.
55-386 The entity assesses
the nature of its promise to transfer the license and
concludes that the nature of its promise is to grant the
customer the right to access the entity’s symbolic
intellectual property. The entity determines that the
licensed intellectual property (that is, the character
names and images) is symbolic because it has no
standalone functionality (the names and images cannot
process a transaction, perform a function or task, or be
played or aired separate from significant additional
production that would, for example, use the images to
create a movie or a show) and the utility of those names
and images is derived from the entity’s past and ongoing
activities such as producing the weekly comic strip that
includes the characters.
-
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.
55-387 Because the nature of
the entity’s promise in granting the license is to
provide the customer with a right to access the entity’s
intellectual property, in accordance with paragraph
606-10-55-58A, the entity accounts for the promised
license as a performance obligation satisfied over
time.
55-388 The entity recognizes
the fixed consideration allocable to the license
performance obligation in accordance with paragraphs
606-10-55-58A and 606-10-55-58C. The entity considers
paragraphs 606-10-25-31 through 25-37 in identifying the
method that best depicts its performance in the license.
Because the contract provides the customer with
unlimited use of the licensed characters for a fixed
term, the entity determines that a time-based method
would be the most appropriate measure of progress toward
complete satisfaction of the performance obligation.
Example 61 — Access to Intellectual
Property
55-395 An entity, a
well-known sports team, licenses the use of its name and
logo to a customer. The customer, an apparel designer,
has the right to use the sports team’s name and logo on
items including t-shirts, caps, mugs, and towels for one
year. In exchange for providing the license, the entity
will receive fixed consideration of $2 million and a
royalty of 5 percent of the sales price of any items
using the team name or logo. The customer expects that
the entity will continue to play games and provide a
competitive team.
55-396 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 the only good or service promised to the
customer in the contract is the license. The additional
activities associated with the license (that is,
continuing to play games and provide a competitive team)
do not directly transfer a good or service to the
customer. Therefore, there is one performance obligation
in the contract.
55-397 To determine whether
the entity’s promise in granting the license provides
the customer with a right to access the entity’s
intellectual property or a right to use the entity’s
intellectual property, the entity assesses the nature of
the intellectual property to which the customer obtains
rights. The entity concludes that the intellectual
property to which the customer obtains rights is
symbolic intellectual property. The utility of the team
name and logo to the customer is derived from the
entity’s past and ongoing activities of playing games
and providing a competitive team (that is, those
activities effectively give value to the intellectual
property). Absent those activities, the team name and
logo would have little or no utility to the customer
because they have no standalone functionality (that is,
no ability to perform or fulfill a task separate from
their role as symbols of the entity’s past and ongoing
activities).
-
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.
55-398 Consequently, the
entity’s promise in granting the license provides the
customer with the right to access the entity’s
intellectual property throughout the license period and,
in accordance with paragraph 606-10-55-58A, the entity
accounts for the promised license as a performance
obligation satisfied over time.
55-399 The entity recognizes
the fixed consideration allocable to the license
performance obligation in accordance with paragraphs
606-10-55-58A and 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. For the consideration that is in
the form of a sales-based royalty, paragraph
606-10-55-65 applies because the sales-based royalty
relates solely to the license that is the only
performance obligation in the contract. The entity
concludes that recognizing revenue from the sales-based
royalty when the customer’s subsequent sales of items
using the team name or logo occur is consistent with the
guidance in paragraph 606-10-55-65(b). That is, the
entity concludes that ratable recognition of the fixed
consideration of $2 million plus recognition of the
royalty fees as the customer’s subsequent sales occur
reasonably depict the entity’s progress toward complete
satisfaction of the license performance obligation.
Connecting the Dots
Airlines with large loyalty programs frequently enter
into agreements with a co-branded credit card partner in which mileage
credits and other consideration (e.g., award travel, upgrades, bag fee
waivers, lounge access) are sold to a financial institution. The mileage
credits are then issued to the financial institution’s credit card
customers, who are also airline loyalty members, as they make purchases
on their co-branded credit card. In these arrangements, the financial
institution will typically make an up-front payment to the airline for
advance purchases of mileage credit and future services to be provided
under the co-branded contract. The “advance services” include the
financial institution’s receiving direct access to the airline’s
customer list. When viewed from the airline’s perspective, these
co-branded agreements include two customers: the financial institution
and the credit card holder. The credit card holder is included as a
customer because of the mileage credits the holder will earn under its
loyalty agreement.
Considerations related to the application of ASC 606 to
these arrangements are discussed below.
Performance
Obligations
Airline entities with these arrangements will need to
carefully evaluate the terms of the agreements to properly identify and
evaluate the promised goods or services that will be transferred to the
customer(s). The significant performance obligations in a co-branded
agreement might include (1) the airline’s sale of the mileage credits to
the financial institution and (2) the right transferred by the airline
to the financial institution that allows the financial institution to
access the airline’s customer list and brand. Use of the airline’s brand
and access to the airline’s customer list would typically be combined as
a separate performance obligation since the financial institution would
use both in its marketing efforts directed at the airline’s customers to
increase its credit card business. For example, from the perspective of
the financial institution, access to only the airline’s brand would have
minimal value without access to the airline’s customer list since the
ability to target a common demographic of airline loyalty members is
valuable to a financial institution. Further, access to the customer
list without the brand would have limited value since the airline
customers are induced to enter into an agreement with the financial
institution by means of offers provided through the airline brand.
Therefore, the combined right to access an airline’s brand and customer
list would generally be considered “highly interdependent or highly
interrelated” under ASC 606-10-25-21(c). In addition, in the airline
industry, it would be uncommon for an airline to separately sell the
right to access its brand and customer list outside of a co-branded
agreement.
For a discussion about identifying performance
obligations in other co-branded credit card arrangements, see Section 5.3.2.3.2.
Allocation of Transaction Price
and Revenue Recognition
In accordance with ASC 606-10-55-54, the right to access
the airline’s customer list and brand is generally viewed as a right of
the financial institution to access the airline’s IP. ASC 606-10-55-58
distinguishes between (1) functional IP (the right to use an entity’s
IP, which promise is fulfilled at a point in time) and (2) symbolic IP
(the right to access an entity’s IP, which promise is fulfilled over
time). The right to access the airline’s customer list and brand over a
contractual period represents symbolic IP since the use of the brand and
customer list is beneficial to the financial institution as a result of
the financial institution’s continued association with the
airline.
As noted above, the other significant performance
obligation in a co-branded arrangement represents the sale of the
mileage credits to the financial institution. The financial institution
will typically transfer the mileage credits to its own customers as the
co-branded credits cards are used. The airline’s performance obligation
would then be satisfied at a point in time upon the redemption of miles
by credit card holders. Thus, the two performance obligations in a
co-branded arrangement have different revenue recognition patterns since
the performance obligation to provide mileage credits is satisfied at a
point in time (when the mileage credits are redeemed by credit card
holders) while the performance obligation to give the financial
institution the right to access the airline’s brand and customer list is
satisfied over the period of the co-branded agreement. Recognition of
the transaction price allocated to the mileage credits would be deferred
until the later of when (1) the miles are used or (2) the miles expire
(if applicable). In contrast, the transaction price allocated to the
right to access the airline brand and customer list would be recognized
over the period of the co-branded arrangement.
Further, the transaction price allocated to the symbolic
IP in a co-branded arrangement is variable since most of the payments
from the financial institution to the airline are dependent on the
successful acquisition of new credit card holders and subsequent use of
the card by the cardholders (which results in the payment of fees from
the financial institution to the airline). Therefore, the airline would
recognize revenue in accordance with the sales- or usage-based royalty
guidance in ASC 606-10-55-65.
12.4.3 Additional Flowchart for Determining the Nature of a License
The flowchart below, which is reproduced from ASC 606-10-55-63A,
provides an overview of the decision-making process for determining the nature
of an entity’s license of IP to a customer (i.e., for determining whether a
license of IP is a right to use or right to access an entity’s IP). Note,
however, that the flowchart does not include all of the guidance an entity is
required to consider and is not intended to be a substitute for the guidance
discussed above.
ASC 606-10
Footnotes
9
In January 2021, the FASB issued ASU 2021-02,
which allows a franchisor that is not a PBE (a “private-company franchisor”)
to use a practical expedient when identifying performance obligations in its
contracts with customers (i.e., franchisees) under ASC 606. See Section 5.3.5 for
additional details.
12.5 Transfer of Control and Recognition
ASC 606-10
55-58C Notwithstanding
paragraphs 606-10-55-58A through 55-58B, revenue cannot be
recognized from a license of intellectual property before
both:
-
An entity provides (or otherwise makes available) a copy of the intellectual property to the customer.
-
The beginning of the period during which the customer is able to use and benefit from its right to access or its right to use the intellectual property. That is, an entity would not recognize revenue before the beginning of the license period even if the entity provides (or otherwise makes available) a copy of the intellectual property before the start of the license period or the customer has a copy of the intellectual property from another transaction. For example, an entity would recognize revenue from a license renewal no earlier than the beginning of the renewal period
Determining when control has been transferred to a customer may be difficult in
certain arrangements related to the licensing of IP, especially those related to
software that is delivered electronically.
12.5.1 Electronic Delivery of Software
The examples below discuss the transfer of control in
arrangements involving electronically delivered software.
Example 12-15
Assessing When Control Is Transferred
to the Customer for a Suite of Software
Licenses
Entity X enters into a five-year license agreement with
Customer B under which B purchases licenses to a suite
of software products consisting of five modules. At the
inception of the arrangement, B is required to make a
nonrefundable payment of $5 million to X for the
licenses to all five modules, and the license term for
the suite of licenses begins on January 1, 20X5.
Customer B has previewed all five modules and accepted
the software as of January 1, 20X5, but has only
obtained the access codes for, and downloaded, four of
the five modules. Customer B installs the modules itself
and expects that it will take three months to install
the four modules. Customer B does not download the fifth
module immediately because of system limitations but
plans to obtain the access code and install the fifth
module once installation of the first four modules is
complete. The access code for the fifth module is
available to B on demand.
In this scenario:
- Customer B is required to pay the nonrefundable license fee at the inception of the arrangement and has accepted the software.
- The license terms have begun.
- The access code for the fifth module is available to B at any time on demand.
Assuming that no other indicators of control are present,
X can reasonably conclude that control of the licenses
for all five modules is transferred to B on January 1,
20X5.
Example 12-16
Assessing When Control Is Transferred to the Customer
When the License Requires an Access Code or Product
Key
Entity X sells software licenses to customers that
represent right-to-use licenses (for which revenue is
recognized at a point in time) and give customers access
to the software via X’s Web site. Customers need either
an access code to download the software or a product key
to activate the software once downloaded. The software
cannot be used on the customer’s hardware without the
access code or the product key.
Entity X may not need to deliver the access code or
product key to the customer to conclude that control of
the software license has been transferred to the
customer. ASC 606-10-55-58B and 55-58C state, in part:
An entity’s promise to provide a customer with
the right to use its intellectual property is
satisfied at a point in time. The entity should
apply paragraph 606-10-25-30 to determine the
point in time at which the license transfers to
the customer.
Notwithstanding paragraphs 606-10-55-58A through
55-58B, revenue cannot be recognized from a
license of intellectual property before both:
-
An entity provides (or otherwise makes available) a copy of the intellectual property to the customer.
-
The beginning of the period during which the customer is able to use and benefit from its right to access or its right to use the intellectual property. That is, an entity would not recognize revenue before the beginning of the license period even if the entity provides (or otherwise makes available) a copy of the intellectual property before the start of the license period or the customer has a copy of the intellectual property from another transaction. [Emphasis added]
Entity X should consider the guidance on control in ASC
606-10-25-23 through 25-26 and the indicators in ASC
606-10-25-30 related to determining when a customer
obtains control of the software license.
In some circumstances, control of the software license
may be transferred to the customer before the access
code or product key is delivered. In particular, there
may be situations in which the access code or product
key has not been delivered but is nonetheless made
available to the customer at any time on demand. In such
circumstances, it will be necessary to consider whether
control has passed to the customer by focusing on the
indicators in ASC 606-10-25-30. For example, if the
customer has accepted the software, nonrefundable
payment has been received, the license term has begun,
and the customer has a current right to request and
receive the access code or product key, X may conclude
that control of the software license has been
transferred even though the access code or product key
has not been provided to the customer. These situations
may be viewed as analogous to bill-and-hold
arrangements, as discussed in ASC 606-10-55-81 through
55-84.
However, if payment terms or acceptance depends on
delivery of the software access code or product key, or
if X is not yet in a position to make the code or key
available, it would be unlikely that X could conclude
that control of a software license has been transferred
until the access code or product key has been provided
to the customer.
Example 12-17
Assessing When Control Is Transferred to the Customer
in a Hosting Arrangement
Entity Y enters into a license and hosting software
arrangement with Customer X that allows X to access via
the Internet and use software that Y physically hosts on
its servers. Customer X is required to pay a
nonrefundable license fee of $1,000 at the inception of
the arrangement. Customer X accepts the software, and
the license term begins once the hosting service
commences.
As part of the arrangement, X has the right to take
possession of the software at any time during the
contract period without incurring additional costs or
diminution of the software’s utility or value. That is,
there are no contractual or practical barriers to X’s
exercising its right to take possession of the software,
and X is able to benefit from the software on its own or
with readily available resources.
Entity Y concludes that the software license and hosting
service are each distinct and that the software license
gives X a right to use Y’s IP. If X exercises its right
to take possession of the software, Y will immediately
provide an access code that will enable X to download
the software.
In this scenario:
-
X is required to pay the nonrefundable license fee at the inception of the arrangement.
-
X has accepted the software, and the license term begins once the hosting service commences.
-
Y has made the access code available to X at any time on demand.
Therefore, assuming that no other indicators affecting
the transfer of control are present, Y can reasonably
conclude that control of the software license is
transferred to X when the license term and hosting
service begin. As a result, (1) the transaction price
allocated to the license is recognized at inception of
the arrangement (corresponding to its transfer of
control at that point in time) and (2) the transaction
price allocated to the hosting service is recognized
over time.
12.5.2 When Control Is Transferred in Reseller Arrangements
Reseller arrangements in which a reseller purchases software from a software
provider (the vendor) and then resells the software to end users are common in
the software industry. In these situations, the reseller is often the vendor’s
customer (rather than the end user). ASC 606-10-55-58C provides that revenue
cannot be recognized from a license of IP before both (1) an entity provides a
copy of the IP to a customer and (2) the period during which the customer can
use and benefit from the IP has begun. Questions arise about when revenue can be
recognized when sales of IP are made to resellers (e.g., distributors) rather
than end users.
Example 12-18
On March 15, 20X0, Vendor A enters into a reseller
arrangement with Reseller B that immediately permits B
to resell 1,000 licenses of A’s software (a form of
functional IP) for a nonrefundable up-front fee of
$200,000. Reseller B plans to resell the functional IP
to end users and will provide all set-up and maintenance
services directly to the end users. There is no
expectation that A will undertake activities to
substantively change the functionality of the IP, and
there are no promised goods or services in the contract
other than the license to the functional IP. Also on
March 15, 20X0, A ships to B a master copy of the
software; B receives the master copy on April 1, 20X0,
and can use it to replicate the software for resale.
Vendor A also makes the software available for download
on March 15, 20X0; however, B intends to use the master
copy rather than the downloaded version to replicate the
software for resale.
Vendor A should recognize revenue on
March 15, 20X0. As noted in ASC 606-10-55-58C, control
of IP cannot be transferred (and revenue cannot be
recognized) before (1) the “entity provides (or
otherwise makes available) a copy of the [IP] to the
customer” and (2) the “beginning of the period during
which the customer is able to use and benefit from its
right to access or its right to use” the IP. In a
reseller arrangement, the customer is not using the
functionality of the software; rather, the customer will
benefit from the software through the ability to resell
the software. Although B intends to use the master copy
to replicate the software, the software is made
available to B on March 15, 20X0, which is also when B
could begin reselling the software. Therefore, on March
15, 20X0, it would be appropriate for A to recognize the
nonrefundable fee of $200,000 as revenue. However, even
if A does not make the software available for download
and only ships B a master copy of the software, A could
recognize the nonrefundable fee of $200,000 as revenue
when it ships the master copy of the software to B on
March 15, 20X0, if control of the master copy is
transferred to B upon shipment (e.g., FOB shipping
point).
12.5.3 Recognition When a License Is Not Distinct From Other Goods or Services
If an entity determines that a license is not distinct and
should therefore be combined with other goods or services in a contract, the
entity will need to evaluate the nature of the combined goods and services to
determine (1) when the performance obligation is satisfied (i.e., at a point in
time or over time) and (2) the appropriate method of measuring progress for
revenue recognition over time, if applicable. This requirement is intended to
ensure that the arrangement is accounted for in a manner that is consistent with
the objective of the revenue standard. That is, revenue is recognized when (or
as) control of the good or service is transferred to the customer.
For example, assume the following:
-
A contract contains a five-year license for the right to access IP and a two-year service agreement, both of which meet the requirements for recognizing revenue over time.
-
The license is not distinct and is therefore combined with the service agreement as a single performance obligation.
-
The license is the predominant part of that combined single performance obligation.
In this example, it would not be appropriate to recognize revenue related to the
five-year license over a two-year period. Rather, the transaction price would be
recognized as revenue as the combined performance obligation (five-year
license plus two-year service agreement) is satisfied. In this case, the timing
of revenue recognition would be determined on the basis of the promised good or
service that is transferred over the longer period (i.e., the five-year
license).
12.6 License Renewals and Modifications
Renewals of and modifications to rights granted in a license arrangement occur
frequently. Entities should consider the nature and provisions of license renewals
and modifications when determining the appropriate accounting treatment. In
addition, the discussions in this section should be considered in conjunction with
those in Chapter 9 on contract
modifications.
Stakeholders questioned how entities should account for license renewals (or
extensions of the license period). Specifically, they asked whether renewals (or
extensions) result in the addition of a distinct license for which control is not
transferred until the new (extended) license period begins, or whether the extended
license period becomes part of the original license for which control may have
already been transferred to the customer (if it is an extension of a license that is
already controlled by the customer). For example, suppose that an entity provides a
right-to-use license to its customer for a three-year period. After two years, the
customer requests an extension of the license period for an additional two years,
which results in the customer’s right to use the license for a total of five years.
Stakeholders questioned whether the entity providing the right-to-use license (i.e.,
a license for which revenue is recognized at a point in time) would recognize
revenue at the point in time when the license term was extended (i.e., after two
years) or at the point in time when the extension period began (i.e., the beginning
of year 4).
As a result, the FASB included specific guidance in ASU 2016-10 to address
stakeholders’ concerns about right-to-use and right-to-access licenses. In
accordance with that guidance, renewals or extensions of licenses should be
evaluated as distinct licenses (i.e., a distinct good or service), and revenue
attributed to the distinct good or service cannot be recognized until (1) the entity
provides the distinct license (or makes the license available) to the customer and
(2) the customer is able to use and benefit from the distinct license. In reaching
this conclusion, the FASB observed in paragraph BC50(a) of ASU 2016-10 that “when
two parties enter into a contract to renew (or extend the license period of) a
license, the renewal contract is not combined with the original license contract
unless [one or more of] the criteria in paragraph 606-10-25-9 [on combining
contracts] have been met.” Therefore, the renewal right should be evaluated in the
same manner as any other additional rights granted after the initial contract (i.e.,
revenue should not be recognized until the customer can begin to use and benefit
from the license, which is generally at the beginning of the license renewal
period).
In addition to providing clarifying guidance in ASC 606-10-55-58C, the FASB provided
the following additional example to clarify the timing of revenue recognition for
renewals:
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.
[ASC 606-10-55-390 through 55-392
omitted.]
Case B — Renewal of the License
55-392A At the end of
the first year of the license period, on December 31, 20X1,
the entity and the customer agree to renew the license to
the recorded symphony for two additional years, subject to
the same terms and conditions as the original license. The
entity will continue to receive fixed consideration of
$10,000 per month during the 2-year renewal period.
55-392B The entity
considers the contract combination guidance in paragraph
606-10-25-9 and assesses that the renewal was not entered
into at or near the same time as the original license and,
therefore, is not combined with the initial contract. The
entity evaluates whether the renewal should be treated as a
new license or the modification of an existing license.
Assume that in this scenario, the renewal is distinct. If
the price for the renewal reflects its standalone selling
price, the entity will, in accordance with paragraph
606-10-25-12, account for the renewal as a separate contract
with the customer. Alternatively, if the price for the
renewal does not reflect the standalone selling price of the
renewal, the entity will account for the renewal as a
modification of the original license contract.
55-392C In determining
when to recognize revenue attributable to the license
renewal, the entity considers the guidance in paragraph
606-10-55-58C and determines that the customer cannot use
and benefit from the license before the beginning of the
two-year renewal period on January 1, 20X3. Therefore,
revenue for the renewal cannot be recognized before that
date.
55-392D Consistent with
Case A, because the customer’s additional monthly payments
for the modification to the license will be made over two
years from the date the customer obtains control of the
second license, the entity considers the guidance in
paragraphs 606-10-32-15 through 32-20 to determine whether a
significant financing component exists.
12.6.1 Early Renewal of a Term-Based License
In conjunction with a term-based license, entities often offer customers a
renewal option under which a customer can renew the contract and extend the
period over which the customer has the right to use the licensed IP. In many
cases, the customer may exercise its option to renew the license before the end
of the initial license term. Although the customer may already be using the
licensed IP, revenue attributable to the renewed license cannot be recognized
until the beginning of the renewal period.
Example 12-19
Entity P enters into a three-year license agreement with
Customer B under which B licenses software from P. The
license includes three years of PCS (e.g., upgrades, bug
fixes, and support). In exchange for the license and
PCS, B pays P total consideration of $2,700, which
consists of a $1,500 up-front payment for the license
and annual installment payments of $400 for PCS payable
at the end of each year. The contract states that B may
extend the license for one-year terms at any point
during the three-year license term for additional
consideration.
Other relevant information includes the following:
-
Entity P has concluded that the software license and PCS are distinct performance obligations.
-
The contract amounts reflect each performance obligation’s stand-alone selling price.
-
The software being licensed is functional IP, and the license gives B the right to use the software. As a result, P concludes that revenue allocated to the license should be recognized at the point in time that the customer obtains control of the license, which is assumed to be at contract inception.
-
The PCS is determined to be a stand-ready obligation that is satisfied by P ratably over the PCS term.
-
The initial contract does not include a material right.
At the end of year 2, B elects to extend the license for
an additional year (i.e., the total license term would
extend from three years to four years) in exchange for
an additional $900 of consideration. Entity P determines
that the additional license and PCS are priced at their
respective stand-alone selling prices ($500 for the
one-year term license and $400 for one year of PCS) and
that the additional one-year term license and associated
PCS are distinct performance obligations.
Entity P cannot recognize revenue allocated to the
one-year renewal of the license granted to B before the
expiration of the initial three-year license term.
In accordance with ASC 606-10-25-12, the contract
extension is accounted for as a separate contract since
the added goods and services (i.e., term license and
PCS) are distinct and priced at their respective
stand-alone selling prices. Although the customer
already has the software subject to the one-year
extension, the addition of one year to the right-to-use
license creates a new distinct license that is
transferred to the customer at the beginning of the
extension period. ASC 606-10-55-58C states that an
entity cannot recognize revenue from a license of IP
before both of the following:
-
The “entity provides (or otherwise makes available) a copy of the [IP] to the customer.”
-
“The beginning of the period during which the customer is able to use and benefit from its right to access or its right to use the [IP].”
ASC 606-10-55-58C further notes that an entity is not
permitted to recognize revenue before the beginning of
the license period even if the customer receives a copy
of the IP before the beginning of the license period.
Specifically, an entity is precluded from recognizing
revenue from a license renewal before the beginning of
the renewal period.
In accordance with the guidance in ASC 606-10-55-58C, P
is precluded from recognizing the consideration
allocated to the one-year term license (i.e., $500)
until the beginning of year 4 (i.e., upon the expiration
of the initial license term and beginning of the renewal
period). If B prepays the $900 before the beginning of
the renewal period, P would recognize that amount as a
contract liability. At the beginning of year 4, P would
recognize $500 immediately upon the transfer of the
one-year right-to-use license to B. Entity P would then
start recognizing the $400 of consideration allocated to
the additional year of PCS ratably over year 4.
Example 12-20
Assume the same facts as in the example
above, except that the additional consideration paid by
Customer B to extend the license for a year is $600
instead of $900 (i.e., the additional license and PCS
are not priced at their stand-alone selling prices,
which are $500 and $400, respectively). At the time of
the extension, Entity P is still entitled to $400 for
the remaining year of PCS it must provide B under the
original contract.
In accordance with ASC 606-10-25-13(a), P would account
for the early renewal (which is a form of a contract
modification) as if it were a termination of the
original contract and the creation of a new contract.
Entity P would combine the additional consideration of
$600 with the consideration promised by B under the
original contract and not yet recognized as revenue by P
(i.e., $400) and allocate the resulting sum to the
remaining performance obligations under the modified
contract. At the time of the modification, the
three-year term license under the original contract had
already been transferred to the customer along with two
years of PCS. Consequently, one year of PCS still must
be transferred under the original contract along with a
one-year term license and an additional year of PCS,
both of which were added as a result of the
modification. The combined consideration of $1,000 ($600
+ $400) would be allocated to the remaining performance
obligations as follows:
Even though the modification is
accounted for as if it were a termination of the
existing contract and the creation of a new
contract, the modification does not alter the
original license term. That is, the modification does
not change the original three-year term license to a
two-year term license. Rather, the modification adds a
one-year term license that begins after the expiration
of the original three-year term license and requires P
to allocate the consideration between the added one-year
term license and the remaining two years of PCS. At the
beginning of year 4, in a manner consistent with the
example above, P would recognize $385 immediately upon
the transfer of the one-year right-to-use license to B.
Further, P would start recognizing the $615 allocated to
the PCS ratably at the beginning of year 3 (the time of
the modification).
12.6.2 Extension of a Right-to-Access License Agreement
Regardless of whether a modification to renew or extend a
license is associated with a right to use IP or a right to access IP, the
modification framework in ASC 606-10-25-12 and 25-13 should be applied. The
example below illustrates the accounting for the extension of a right-to-access
license agreement.
Example 12-21
Entity X and Customer Y enter into a license agreement
under which Y is provided the right to access X’s IP for
three years for $3 million. After one year, X and Y
agree to extend the contract for an additional two years
for $1.8 million.
Assume that X has concluded that the additional two years
of access to its IP are distinct from access to its IP
over the initial three-year period.
Entity X should apply the modification guidance in ASC
606-10-25-12 and 25-13 (see Section 9.2). Entity X should first
determine whether the contract modification meets the
criteria in ASC 606-10-25-12 to be accounted for as a
separate contract.
In this example, the criterion in ASC
606-10-25-12(a) is met because the scope of the contract
is increased by two years and the right to access X’s IP
over that period is considered distinct in accordance
with ASC 606-10-25-19 through 25-22. The determination
that the right to access IP for an additional two years
provides additional goods or services that are distinct
is consistent with paragraph BC72 of ASU 2016-10, which
states that in many right-to-access license
arrangements, “the license may constitute a series of
distinct goods or services that are substantially the
same and have the same pattern of transfer to the
customer in accordance with paragraph 606-10-25-14(b)
(for example, a series of distinct periods [month,
quarter, year] of access).”
Entity X must also consider whether the contract
modification meets the criterion in ASC 606-10-25-12(b),
which requires the modification to increase the price of
the contract “by an amount of consideration that
reflects the entity’s standalone selling prices of the
additional promised goods or services.” If X determines
that the contract modification increases the price of
the contract by an amount of consideration that reflects
the entity’s stand-alone selling price for the added
rights to access the IP, the modification will be
accounted for as a separate contract. When considering
whether the price charged to the customer represents the
stand-alone selling price of additional distinct
promised goods or services, entities are allowed to
adjust the stand-alone selling price to reflect a
discount for costs they do not incur because they have
modified a contract with an existing customer. For
example, the renewal price that an entity charges a
customer is sometimes lower than the initial price
because the entity recognizes that the expenses
associated with obtaining a new customer can be excluded
from the renewal price.
If X determines that the contract modification does not
increase the price of the contract by an amount of
consideration that reflects the entity’s stand-alone
selling price of the added rights to access the IP, the
modification will be accounted for in accordance with
ASC 606-10-25-13. Since the added rights to access the
IP are considered distinct, X should account for the
modification as a termination of the existing contract
and the creation of a new contract in accordance with
ASC 606-10-25-13(a).
Regardless of whether the contract modification is
accounted for as a separate contract or as a termination
of the original contract and the creation of a new
contract, the modification should be accounted for
prospectively. That is, no cumulative-effect adjustment
should be recorded as a result of the modification.
If X determines that the $1.8 million represents the
stand-alone selling price of the right to access its IP
during the extension period, X would account for the
right to access its IP in years 4 and 5 as a separate
contract. Revenue for each year of the five-year
arrangement would be recorded as follows:
If X determines that the $1.8 million does not represent
the stand-alone selling price of the right to access its
IP during the extension period, X would account for the
modification as a termination of the original contract
and the creation of a new contract. Revenue for each
year of the five-year arrangement would then be recorded
as follows:
12.6.3 Renewals of PCS in a Software Arrangement
It is common for an entity’s software contract with a customer
to include both a software license and PCS for a defined term (e.g., 12 months).
In some cases, the software license is perpetual, or the term of the license is
greater than the initial PCS term. After the initial PCS term, the customer may
be entitled to renew the PCS at a renewal rate stated in the contract. Questions
have arisen about how to account for (1) a reinstatement of PCS after the
initial PCS term has lapsed (see Section
12.6.3.1) and (2) an option to renew PCS when it is not distinct
from a perpetual software license (see Section
12.6.3.2).
12.6.3.1 Reinstatement of PCS After Customer Lapse
As noted in Section
12.6.3, an entity could grant a license to software on a
perpetual basis or for a term greater than the initial PCS term, with an
option to renew the PCS at a stated renewal rate. If the customer does not
elect to renew the PCS, the entity may not have an obligation (explicit or
implied) to provide PCS to the customer after the initial PCS term. While
the customer does not have the right to receive software updates or support
if it does not renew the PCS, the customer retains the right to use the
software in its then current state.
Although the entity does not have a contractual, legal, or implied obligation
to provide PCS to the customer if the customer does not renew the PCS, the
entity may continue to provide PCS as a courtesy to the customer. However,
if there is no enforceable contract during the lapse period, the customer
might not have the legal right to retain and use the benefits, including any
software updates or enhancements, provided by the PCS during the lapse
period. If the customer renews the PCS after the initial PCS term has
lapsed, the entity may require the customer to pay a reinstatement fee equal
to the amount that the customer would have paid for the PCS during the lapse
period in addition to the fee for the remaining renewal period.
To account for a contract with a customer to reinstate PCS,
an entity can use either of the following two methods depending on the
nature of the PCS:10
-
Cumulative catch-up method (“Alternative A”) — Upon the customer’s reinstatement of the PCS, the entity should record a cumulative adjustment to revenue. Under this alternative, the fee paid by the customer to reinstate the PCS should be allocated to both the PCS provided during the lapse period (software updates and enhancements provided as a courtesy during the lapse period if control of these items is transferred to the customer upon reinstatement of the PCS) and the future services to be provided over the remaining PCS term after the reinstatement. The amount allocated to the software updates and enhancements provided during the lapse period is recognized immediately because control is transferred at the point in time at which the PCS is reinstated. The amount allocated to future services is recognized over time as these services are provided.
-
Prospective method (“Alternative B”) — Upon the customer’s reinstatement of the PCS, the entity should allocate the consideration in the contract (i.e., the reinstatement fee equal to what the customer would have paid during the lapse period and the fee for additional PCS) to the remaining months of PCS to be provided to the customer. This amount is recognized over time as the services are provided.
We believe that Alternative A is more appropriate if control over any updates
or software enhancements already received by the customer (i.e., the right
to legally retain bug fixes, updates, and enhancements that were provided
during the lapse period) is transferred to the customer only at the point in
time at which the PCS is reinstated. Under Alternative A, no revenue should
be recognized during the lapse period because there is no contract with the
customer. However, upon the customer’s reinstatement of the PCS, the entity
should recognize a cumulative adjustment to revenue in an amount that
corresponds to the rights transferred to the customer upon reinstatement
(which, under the facts of this scenario, is the reinstatement fee equal to
the amount that the customer would have paid for the PCS during the lapse
period). Although the customer may receive PCS during the lapse period, the
customer does not have the legal right to retain the benefits from the PCS
during this period; however, the rights to retain and use the benefits,
updates, and enhancements are transferred to the customer if the customer
renews the PCS. As noted above, the total fee charged to the customer
includes a reinstatement fee equal to the amount that the customer would
have paid for the PCS during the lapse period and an amount related to the
PCS to be provided under the remaining PCS term. Therefore, the fee paid by
the customer upon renewal is related to both the PCS still to be provided
under the contract and the PCS provided during the lapse period.
Because the nature of PCS can differ among entities, additional consideration
may be required if the entity does not provide upgrades, enhancements, or
bug fixes as part of the PCS (e.g., when the PCS includes only support). In
such cases, Alternative B may be more appropriate because the customer may
not receive incremental rights upon reinstatement.
Example 12-22
Entity V provides hospitals with communications
solutions, which consist of hardware, software, and
PCS for the software. On January 1, 20X1, V enters
into a contract with Customer C to grant C a
perpetual license to V’s software and 12 months of
PCS. The contract states that the PCS may be renewed
on an annual basis for $1,200. Entity V concludes
that the $1,200 represents the stand-alone selling
price of the PCS. In addition, V concludes that its
obligation to provide PCS is a stand ready
obligation that provides C with a benefit ratably
over the contract term.
At the end of the initial 12-month term, C does not
elect to renew the PCS and therefore does not make
any further payment. Although V does not have an
explicit or implicit obligation to provide any
services, V continues to provide the PCS, including
updates and enhancements to the software, as a
courtesy to C because V expects that C will
eventually reinstate the PCS. However, C does not
have the legal right to retain or use the benefits
of the updates or enhancements to the software until
it reinstates the PCS.
On April 1, 20X2 (i.e., three months
after the PCS has lapsed), C reinstates the PCS by
paying V $1,200, of which $300 represents a
reinstatement fee equal to the amount that C would
have paid for the PCS during the lapse period. The
new PCS term expires on December 31, 20X2. The
$1,200 fee paid by C is intended to compensate V for
the three months of PCS provided during the lapse
period and the remaining nine months of PCS to be
provided over the remaining period of the new PCS
term. Entity V concludes that control of the rights
to retain and use the benefits provided by the PCS
(i.e., the right to retain or use the enhanced and
updated software) during the three-month lapse
period is immediately transferred to the customer
once the PCS is reinstated.
Upon reinstatement of the PCS, it
would be acceptable for V to recognize $300 as
revenue immediately because this represents the
value of the rights that are transferred to C
immediately upon reinstatement of the PCS. In that
case, V would then recognize $900 as revenue over
the remaining contract period ending on December 31,
20X2.
12.6.3.2 Options to Renew PCS When PCS Is Not Distinct From a Perpetual Software License
The example below illustrates the identification of material
rights in a contract involving renewable PCS that is not distinct from a
perpetual software license.
Example 12-23
On January 1, 20X9, Company LN enters into a contract
with a customer to transfer a perpetual antivirus
software license and provide unspecified software
updates as PCS for one year in exchange for an
up-front, nonrefundable fee of $3,000, which is the
standard price paid by all new customers. Company LN
has concluded that the software license and PCS are
not distinct because the functionality and utility
of the software are highly dependent on the PCS and
vice versa. The updates significantly modify the
functionality of the software by permitting the
software to protect the customer from a significant
number of additional viruses that the software did
not protect against previously. The updates are also
integral to maintaining the utility of the software
license to the customer. Therefore, the transfer of
a perpetual antivirus software license and the
obligation to provide PCS constitute a single
performance obligation.
At the end of the year, the customer has an option to
renew the PCS on an annual basis for $300. The
customer may exercise this option each year on an
indefinite basis. The customer is expected to renew
the PCS for four additional years after the first
year of the contract.
The annual renewal options exercisable by the
customer each represent a material right in LN’s
contract. Since the license is not distinct
(separable) from the PCS, the customer is
effectively renewing the single performance
obligation (the combined license and PCS) each year
even though the software that is being provided is
in the form of a perpetual license.
Therefore, each annual renewal option represents a
material right because the renewal options enable
LN’s customer to renew the contract at a price that
is lower than the amount that new customers are
typically charged (i.e., only $300 is required to
renew as compared with the $3,000 that new customers
must pay). Because the material rights are accounted
for as separate performance obligations, LN
allocates the total transaction consideration of
$3,000 for the first year to the identified
performance obligations (services for the first-year
contract and the material rights) on a relative
stand-alone selling price basis. As described in ASC
606-10-55-45, as a practical alternative to
estimating the stand-alone selling price of the
renewal options, LN may be able to allocate the
transaction price to the renewal options (i.e., the
material rights) “by reference to the goods or
services expected to be provided and the
corresponding expected consideration.” In accordance
with ASC 606-10-55-42, the amount allocated to each
annual renewal option (i.e., the material rights)
would be recognized (1) as LN provides the service
to which the renewal option is related or (2) when
the renewal options expire.
12.6.4 Cloud Conversion or Switching Rights
Some entities in the software industry enter into contracts that
include (or are subsequently modified to include) an option that allows the
customer to convert from an on-premise license arrangement to a cloud-based
arrangement under which the software is hosted (e.g., SaaS). This issue has
become more prevalent because customers of software entities frequently migrate
from on-premise software solutions to cloud-based platforms. Often, when a
customer converts from an on-premise software arrangement to a SaaS arrangement,
the customer will lose or forfeit its rights to the on-premise version of the
software. Views differ on how to account for the revocation of the initial
licensing rights and the conversion to a hosted solution.
From inception or after modification, a software arrangement may
include a feature that allows a customer to convert a nonexclusive on-premise
term-based software license to a cloud-based or hosted software solution (e.g.,
a SaaS arrangement)11 for the same software (i.e., software with the same functionality and
features). An entity may also modify a nonexclusive on-premise term-based
software arrangement to immediately convert it to a SaaS arrangement. Further,
an entity’s software arrangement may allow a customer to (1) deploy a certain
number of licenses to software (e.g., 1,000 seats) and (2) use discretion to
determine how many licenses to deploy on an on-premise basis or as SaaS at any
point in time or at discrete points in time during the arrangement term. Cloud
conversion or switching rights vary widely in practice, and the determination of
the appropriate accounting for an arrangement that provides for such rights will
depend on the particular complexities involved.
In accordance with the guidance in ASC 606, revenue from
on-premise software licenses is typically recognized at the point in time when
both (1) the entity provides (or otherwise makes available) a copy of the
software to the customer and (2) the period in which the customer is able to use
and benefit from the license has begun. Revenue from a SaaS arrangement is
typically recognized over time because the performance obligation is likely to
meet the conditions for such recognition, particularly if the SaaS is a
stand-ready obligation. While ASC 606 includes guidance on contract
modifications, material rights, and sales with a right of return, it does not
directly address transactions in which a nonexclusive software license is
revoked or converted to a SaaS arrangement. As a result, there are diverse views
on the accounting for such arrangements, particularly those in which a
nonexclusive on-premise software license for which revenue is recognized at a
point in time is converted to a SaaS arrangement for the same underlying
software product for which revenue is recognized over time.
We believe that there could be more than one acceptable accounting model for
certain types of cloud conversion or switching arrangements. The next sections
provide illustrative examples of such arrangements and discuss views on how
entities may account for them. However, the examples are not all-inclusive, and
entities should carefully consider their specific facts and circumstances in
determining the appropriate accounting model. In addition, the accounting views
discussed for each example may not necessarily be the only methods that are
acceptable.
12.6.4.1 Initial Contract Includes a Cloud Conversion Right
The example below illustrates an initial nonexclusive on-premise term-based
software license contract that includes the right to convert the on-premise
software license to a SaaS arrangement.
Example 12-24
On January 1, 20X0, Entity A enters into a
noncancelable two-year contract with a customer for
an up-front fee of $1 million to provide a
nonexclusive on-premise software license with
maintenance or PCS for 100 seats and a right to
convert any of the on-premise license seats to a
SaaS arrangement at the beginning of the second year
(i.e., January 1, 20X1). The SaaS has the same
functionality and features as the on-premise
software but would be hosted by A instead of being
provided on an on-premise basis. Upon exercise of
the conversion right, the customer would be required
to forfeit the on-premise software license seats and
related PCS, and the conversion is irrevocable
(i.e., the customer cannot convert back to an
on-premise software license). Upon conversion, the
customer would be required to pay an incremental fee
of $500 per seat and would receive a credit for a
pro rata portion of the “unused” on-premise software
license and related PCS to apply to the price the
customer would pay for the SaaS.
Entity A has similar
arrangements with other customers and expects the
customer to convert 50 seats at the beginning of the
second year. The stand-alone selling prices are as
follows:
12.6.4.1.1 Alternative 1A — Material Right Model (Preferred View)
Under this alternative, an entity should
determine whether the conversion right represents a material right. ASC
606-10-55-42 through 55-44 state the following:
ASC 606-10
55-42 If, in a contract,
an entity grants a customer the option to acquire
additional goods or services, that option gives
rise to a performance obligation in the contract
only if the option provides a material right to
the customer that it would not receive without
entering into that contract (for example, a
discount that is incremental to the range of
discounts typically given for those goods or
services to that class of customer in that
geographical area or market). If the option
provides a material right to the customer, the
customer in effect pays the entity in advance for
future goods or services, and the entity
recognizes revenue when those future goods or
services are transferred or when the option
expires.
55-43 If a customer has
the option to acquire an additional good or
service at a price that would reflect the
standalone selling price for that good or service,
that option does not provide the customer with a
material right even if the option can be exercised
only by entering into a previous contract. In
those cases, the entity has made a marketing offer
that it should account for in accordance with the
guidance in this Topic only when the customer
exercises the option to purchase the additional
goods or services.
55-44 Paragraph
606-10-32-29 requires an entity to allocate the
transaction price to performance obligations on a
relative standalone selling price basis. If the
standalone selling price for a customer’s option
to acquire additional goods or services is not
directly observable, an entity should estimate it.
That estimate should reflect the discount that the
customer would obtain when exercising the option,
adjusted for both of the following:
-
Any discount that the customer could receive without exercising the option
-
The likelihood that the option will be exercised.
Under the material right guidance, an entity provides a material right if
the customer has the option to purchase the SaaS at a discount that is
incremental to the range of discounts typically provided for the SaaS to
that class of customer in similar circumstances. Any incremental fee the
customer is required to pay to exercise the conversion right is compared
with the stand-alone selling price of the SaaS. While the customer may
receive a credit for the “unused” portion of the on-premise term-based
software license and related PCS, only the incremental fee to exercise
the right is considered. This is because under Alternative 1A, a
nonexclusive on-premise term-based software license is not subject to
the right of return guidance since the entity does not receive an asset
back when the right is exercised (i.e., there is no return of an
asset).12 That is, the entity is not compensated with an asset of any value
as a result of the conversion since it can replicate a nonexclusive
software license for sale to any of its customers for a nominal cost. If
the incremental fee that the customer is required to pay to convert to
the SaaS reflects the stand-alone selling price of the SaaS, no material
right exists under ASC 606-10-55-43. Instead, the conversion right is
accounted for only if and when it is exercised. On the other hand, if
the conversion right represents a material right because the incremental
fee is less than the stand-alone selling price of the SaaS, that
material right would be accounted for as a separate performance
obligation. In accordance with ASC 606-10-55-44, the entity would
estimate the stand-alone selling price of the material right as the
discount the customer would obtain when exercising the material right,
adjusted for any discount the customer could receive without exercising
the option and the likelihood that the option will be exercised. If the
conversion option is exercised, the amount allocated to the material
right plus any incremental fee paid would generally be recognized over
the remaining term of the SaaS (and the PCS if not all licenses are
converted).
In Example 12-24,
A would need to assess whether the option to receive the SaaS at a
discount represents a material right. Because the incremental fee to be
paid by the customer of $500 per seat per year is significantly less
than the stand-alone selling price for the SaaS of $5,500 per seat per
year, A would conclude that a material right exists at contract
inception. Entity A could estimate the material right’s stand-alone
selling price as the $5,000 per seat per year discount ($5,500 SaaS
stand-alone selling price − $500 incremental fee to be paid), adjusted
for the likelihood that the option will be exercised.13 We believe that it would also be acceptable for A to estimate the
stand-alone selling prices of the on-premise software license and the
PCS by applying a similar adjustment for the likelihood that the option
will be exercised (which could truncate the term of the on-premise
software license and the PCS). For example, A might estimate the
stand-alone selling prices of the on-premise software license and the
PCS under the assumption that 50 seats of the license and related PCS
will have only a one-year term if customers are expected to convert half
the seats of the license to SaaS after one year.
Assume that A determines that the relative stand-alone selling price
allocation of the transaction price results in allocations to the
on-premise software license, PCS for 20X0, PCS for 20X1, and the
material right of $600,000, $100,000, $50,000, and $250,000,
respectively.14 Entity A will recognize $600,000 of revenue on January 1, 20X0,
for the on-premise software license and $100,000 for PCS ratably over
20X0. Revenue is deferred for the $50,000 allocated to PCS for 20X1 and
the $250,000 allocated to the material right, and those amounts are
recognized as contract liabilities. If the customer elects to exercise
the conversion right on 100 seats on January 1, 20X1, A would assess its
policy for accounting for the exercise of an option that includes a
material right and apply either of the following:
-
Separate contract model — The remaining unrecognized revenue of $50,000 related to PCS is recognized immediately since PCS for all 100 seats is forfeited and therefore will not be provided in 20X1. Revenue of $300,000, which is calculated by adding the material right allocation of $250,000 and the incremental fee of $50,000 ($500 incremental fee × 100 seats), is recognized over the remaining one-year SaaS term.
-
Contract modification model — Revenue of $350,000, which is calculated by adding the remaining unrecognized revenue of $50,000 related to PCS, the material right allocation of $250,000, and the incremental fee of $50,000, is recognized over the remaining one-year SaaS term.
Alternative 1A may be less costly to implement than Alternative 1B below
because the stand-alone selling price of the material right is estimated
only at contract inception and is not subsequently revised. In addition,
because the right of return model is not applied, the variable
consideration constraint would likewise not be applicable. Therefore,
revenue recognition could potentially be less volatile under the
material right model than under the right of return model discussed
below.
12.6.4.1.2 Alternative 1B — Right of Return Model (Acceptable View)
Under this alternative, an entity applies
the right of return guidance when accounting for the potential that a
nonexclusive on-premise term-based software license will be converted to
a SaaS arrangement. ASC 606-10-55-22 through 55-26 state the
following:
ASC 606-10
55-22 In some contracts,
an entity transfers control of a product to a
customer and also grants the customer the right to
return the product for various reasons (such as
dissatisfaction with the product) and receive any
combination of the following:
-
A full or partial refund of any consideration paid
-
A credit that can be applied against amounts owed, or that will be owed, to the entity
-
Another product in exchange.
55-23 To account for the
transfer of products with a right of return (and
for some services that are provided subject to a
refund), an entity should recognize all of the
following:
-
Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for the products expected to be returned)
-
A refund liability
-
An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.
55-24 An entity’s promise
to stand ready to accept a returned product during
the return period should not be accounted for as a
performance obligation in addition to the
obligation to provide a refund.
55-25 An entity should
apply the guidance in paragraphs 606-10-32-2
through 32-27 (including the guidance on
constraining estimates of variable consideration
in paragraphs 606-10-32-11 through 32-13) to
determine the amount of consideration to which the
entity expects to be entitled (that is, excluding
the products expected to be returned). For any
amounts received (or receivable) for which an
entity does not expect to be entitled, the entity
should not recognize revenue when it transfers
products to customers but should recognize those
amounts received (or receivable) as a refund
liability. Subsequently, at the end of each
reporting period, the entity should update its
assessment of amounts for which it expects to be
entitled in exchange for the transferred products
and make a corresponding change to the transaction
price and, therefore, in the amount of revenue
recognized.
55-26 An entity should
update the measurement of the refund liability at
the end of each reporting period for changes in
expectations about the amount of refunds. An
entity should recognize corresponding adjustments
as revenue (or reductions of revenue).
Under Alternative 1B, an on-premise software license is generally treated
like a tangible product, and the right of return guidance applies to the
exchange of a product for another product in accordance with ASC
606-10-55-22(c). However, while an entity would generally record an
asset for its right to recover a tangible product, an entity would not
record an asset for its right to recover a nonexclusive software license
in accordance with ASC 606-10-55-23(c) since the returned license has no
value to the entity. Therefore, in applying the right of return
guidance, the entity would estimate and recognize an adjustment to the
transaction price (and reduce revenue) at contract inception to account
for the potential conversion.15 The right of return would be accounted for as variable
consideration, subject to the constraint in ASC 606-10-32-11 and
32-12.16 The estimate of the variable consideration associated with the
right of return would be reassessed at the end of each reporting period
in accordance with ASC 606-10-55-25 and 55-26, with changes in the
estimate recognized as an adjustment to revenue. If the conversion right
is exercised, the amount previously deferred as a liability17 plus the incremental fee paid would generally be recognized as
revenue over the remaining term of the SaaS (and the PCS for any
licenses that are not converted).
In Example 12-24,
A would need to determine its estimate of variable consideration and how
much of that consideration, if any, should be constrained. Assume that A
determines that $500,000 of the $1 million transaction price is variable
consideration, which is calculated as ($4,000 on-premise software
license stand-alone selling price + $1,000 PCS stand-alone selling
price) × 100 seats × 1 year. In addition, assume that A estimates
variable consideration of $250,000 — calculated as ($4,000 on-premise
software license stand-alone selling price + $1,000 PCS stand-alone
selling price) × 50 seats × 1 year — and concludes that none of the
estimated variable consideration should be constrained.18 Therefore, A will recognize revenue of $600,000, or ($4,000
on-premise software license stand-alone selling price × 100 seats × 1
year) + ($4,000 on-premise software license stand-alone selling price ×
50 seats × 1 year), on January 1, 20X0, for the on-premise software
license and $100,000, or $1,000 PCS stand-alone selling price × 100
seats × 1 year, for PCS ratably over 20X0. In addition, A will recognize
a liability of $250,000, or $1 million − $500,000 fixed consideration −
$250,000 variable consideration, for the credit that the customer is
expected to receive for the on-premise software license and PCS that are
expected to be forfeited. Entity A will reassess its estimate of
variable consideration at the end of each reporting period.
Assume that on December 31, 20X0, A revises its estimate of the liability
associated with the right of return to $500,000 because it now expects
that the customer will convert all 100 seats to a SaaS arrangement.
Entity A will reverse $200,000 of revenue for the incremental 50 seats
of on-premise software expected to be forfeited ($4,000 on-premise
software license stand-alone selling price × 50 seats × 1 year) and
reclassify the $50,000 PCS contract liability for the incremental PCS
expected to be forfeited ($1,000 PCS stand-alone selling price × 50
seats × 1 year) for a total increase in liability of $250,000 related to
the credit expected to be granted to the customer. If the customer
elects to exercise the conversion right on 100 seats on January 1, 20X1,
revenue of $550,000, which is calculated by adding the liability of
$500,000 and the incremental fee of $50,000 ($500 incremental fee × 100
seats × 1 year), is recognized over the remaining one-year SaaS
term.
Because A’s initial estimate of the liability for the credit expected to
be granted to the customer was not sufficient, a significant amount of
revenue ultimately had to be reversed in a subsequent reporting period.
This example highlights the importance of critically evaluating how much
revenue should be constrained to ensure that it is probable that a
significant reversal in cumulative revenue recognized will not occur.
Given the risk of overestimating the amount of variable consideration to
which an entity can expect to be entitled for the on-premise software
license and PCS, we believe that many software entities, particularly
those that do not have sufficient historical data on conversion rates,
may find it challenging to determine an appropriate estimate of variable
consideration and constraint as required under Alternative 1B.
12.6.4.1.3 Tabular Summary of Alternatives 1A and 1B
The following table summarizes the timing
of revenue recognition under Alternatives 1A and 1B:
12.6.4.2 Initial Contract Is Modified to Convert a Term-Based License to SaaS
The example below illustrates a situation in which a
nonexclusive on-premise term-based software license contract (1) initially
does not include the right to convert the on-premise software
license to a SaaS arrangement but (2) is subsequently modified to
immediately convert the on-premise software license to a SaaS
arrangement.
Example 12-25
On January 1, 20X0, Entity B enters into a
noncancelable two-year contract with a customer for
an up-front fee of $1 million to provide a
nonexclusive on-premise software license with PCS
for 100 seats. At contract inception, there is no
explicit or implied right to convert any of the
on-premise license seats to a SaaS arrangement.19
On January 1, 20X1, B and the customer modify the
contract to convert 50 seats of the on-premise
software license to a SaaS arrangement for the
remaining term. The SaaS has the same functionality
and features as the licensed software but would be
hosted by B instead of being provided on an
on-premise basis. The customer is required to
forfeit the 50 on-premise software license seats and
related PCS (but will retain the other 50 seats on
an on-premise basis with the related PCS for the
remaining term), and the conversion is irrevocable
(i.e., the customer cannot convert back to an
on-premise software license). Upon contract
modification and conversion, the customer is
required to pay an incremental fee of $500 per seat
and receives a credit for the pro rata portion of
the “unused” term-based license and related PCS to
apply to the price the customer will pay for the
SaaS.
The stand-alone
selling prices are as follows:
12.6.4.2.1 Alternative 2A — Prospective Model (Preferred View)
Under this alternative, an entity should
evaluate the contract modification guidance since the contract has been
modified (i.e., there is a change in the scope and price). ASC
606-10-25-12 and 25-13 state the following:
ASC 606-10
25-12 An entity shall
account for a contract modification as a separate
contract if both of the following conditions are
present:
-
The scope of the contract increases because of the addition of promised goods or services that are distinct (in accordance with paragraphs 606-10-25-18 through 25-22).
-
The price of the contract increases by an amount of consideration that reflects the entity’s standalone selling prices of the additional promised goods or services and any appropriate adjustments to that price to reflect the circumstances of the particular contract. For example, an entity may adjust the standalone selling price of an additional good or service for a discount that the customer receives, because it is not necessary for the entity to incur the selling-related costs that it would incur when selling a similar good or service to a new customer.
25-13 If a contract
modification is not accounted for as a separate
contract in accordance with paragraph
606-10-25-12, an entity shall account for the
promised goods or services not yet transferred at
the date of the contract modification (that is,
the remaining promised goods or services) in
whichever of the following ways is applicable:
-
An entity shall account for the contract modification as if it were a termination of the existing contract, and the creation of a new contract, if the remaining goods or services are distinct from the goods or services transferred on or before the date of the contract modification. The amount of consideration to be allocated to the remaining performance obligations (or to the remaining distinct goods or services in a single performance obligation identified in accordance with paragraph 606-10-25-14(b)) is the sum of:
-
The consideration promised by the customer (including amounts already received from the customer) that was included in the estimate of the transaction price and that had not been recognized as revenue and
-
The consideration promised as part of the contract modification.
-
-
An entity shall account for the contract modification as if it were a part of the existing contract if the remaining goods or services are not distinct and, therefore, form part of a single performance obligation that is partially satisfied at the date of the contract modification. The effect that the contract modification has on the transaction price, and on the entity’s measure of progress toward complete satisfaction of the performance obligation, is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) at the date of the contract modification (that is, the adjustment to revenue is made on a cumulative catch-up basis).
-
If the remaining goods or services are a combination of items (a) and (b), then the entity shall account for the effects of the modification on the unsatisfied (including partially unsatisfied) performance obligations in the modified contract in a manner that is consistent with the objectives of this paragraph.
The contract modification is accounted for as a termination of the
existing contract and the creation of a new contract in accordance with
ASC 606-10-25-13(a) because the modification does not solely add goods
or services at their stand-alone selling prices (i.e., goods and
services are also forfeited, and any incremental fee paid for the SaaS
is not at its stand-alone selling price) and the remaining SaaS (and PCS
for any licenses that are not converted) is distinct. The contract
modification is accounted for prospectively, and any unrecognized
revenue that was included in the transaction price from the original
contract plus any additional consideration paid as part of the contract
modification is recognized over the remaining term of the SaaS (and the
PCS for any licenses that are not converted). There is no adjustment to
or reversal of revenue for the “unused” portion of the on-premise
software license since the modification is accounted for prospectively
(i.e., revenue is not “recycled”). Further, the entity does not receive
a “returned” asset since, as similarly noted in the discussion of
Alternative 1A, the entity does not receive an asset of any value back.
Therefore, none of the pro rata credit provided for the “unused” portion
of the on-premise software license that has been forfeited would be
included as part of the consideration allocated to the SaaS (and PCS for
any licenses that are not converted).
In Example 12-25,
B will recognize revenue of $800,000 ($4,000 on-premise software license
stand-alone selling price × 100 seats × 2 years) on January 1, 20X0, for
the on-premise software license and $100,000 ($1,000 PCS stand-alone
selling price × 100 seats × 1 year) for PCS ratably over 20X0. When the
contract is modified on January 1, 20X1, B has a contract liability
related to PCS of $100,000 and receives incremental consideration of
$25,000 ($500 incremental fee × 50 seats). Entity B will therefore
recognize $125,000 ($100,000 + $25,000) for both PCS and the SaaS over
the remaining one-year term.20
12.6.4.2.2 Alternative 2B — Return Model (Acceptable View)
Under this alternative, in a manner similar to that in Alternative 2A,
the contract modification is accounted for as a termination of the
existing contract and the creation of a new contract because the
modification does not solely add goods or services at their stand-alone
selling prices (i.e., goods and services are also forfeited, and any
incremental fee paid for the SaaS is not at its stand-alone selling
price) and the remaining SaaS (and PCS if not all licenses are
converted) is distinct. However, unlike Alternative 2A, Alternative 2B
treats the “unused” portion of the on-premise software license as being
effectively returned for a credit that can be applied toward the
purchase of the SaaS. Therefore, revenue associated with the unused
portion of the returned on-premise software license is reversed. The
amount of revenue reversed (i.e., the credit associated with the unused
portion of the returned on-premise software license), together with any
unrecognized revenue that was included in the transaction price from the
original contract and any additional consideration paid as part of the
contract modification, is recognized over the remaining term of the SaaS
(and the PCS for any licenses that are not converted).
In Example 12-25,
B will recognize revenue of $800,000 ($4,000 on-premise software license
stand-alone selling price × 100 seats × 2 years) on January 1, 20X0, for
the on-premise software license and $100,000 ($1,000 PCS stand-alone
selling price × 100 seats × 1 year) for PCS ratably over 20X0. When the
contract is modified on January 1, 20X1, B will reverse revenue of
$200,000 ($4,000 on-premise software license stand-alone selling price ×
50 seats × 1 year) for the returned portion of the on-premise software
license. Entity B also has a contract liability related to PCS of
$100,000 and receives incremental consideration of $25,000 ($500
incremental fee × 50 seats). Entity B will therefore recognize revenue
of $325,000 ($200,000 + $100,000 + $25,000) for both PCS and the SaaS
over the remaining one-year term.21
12.6.4.2.3 Tabular Summary of Alternatives 2A and 2B
The following table summarizes the timing
of revenue recognition under Alternatives 2A and 2B:
12.6.4.3 Initial Contract Is Modified to Add a Cloud Conversion Right
The example below illustrates a situation in which a
nonexclusive on-premise term-based software license contract (1) initially
does not include the right to convert the on-premise software
license to a SaaS arrangement but (2) is subsequently modified to add a
right to convert the on-premise software license to a SaaS arrangement.
Example 12-26
On January 1, 20X0, Entity C enters
into a noncancelable three-year contract with a
customer for an up-front fee of $3 million to
provide a nonexclusive on-premise software license
with PCS for 100 seats. At contract inception, there
is no explicit or implied right to convert any of
the on-premise license seats to a SaaS
arrangement.22
On January 1, 20X1, C and the
customer modify the contract to add a right to
convert any of the on-premise license seats to a
SaaS arrangement at the beginning of the third year
(i.e., January 1, 20X2). The SaaS has the same
functionality and features as the on-premise
software but would be hosted by C instead of being
provided on an on-premise basis. As in Example 12-24, the
customer would be required to forfeit the on-premise
software license seats and related PCS upon exercise
of the conversion right, and the conversion is
irrevocable (i.e., the customer cannot convert back
to an on-premise software license). Upon conversion,
the customer would be required to pay an incremental
fee of $1,000 per seat and would receive a credit
for a pro rata portion of the “unused” on-premise
software license and related PCS to apply to the
price the customer would pay for the SaaS.
The
stand-alone selling prices are as follows:
12.6.4.3.1 Alternative 3A — Prospective Material Right Model (Preferred View)
Under this alternative, in a manner similar to that under Alternative 2A,
the contract modification is accounted for as a termination of the
existing contract and the creation of a new contract because the
modification does not solely add goods or services at their stand-alone
selling prices (i.e., a conversion right is added for no additional
consideration, and any incremental fee to be paid for the SaaS is not at
its stand-alone selling price) and the remaining performance obligations
(PCS and a material right) are distinct. The contract modification is
accounted for prospectively, and any unrecognized revenue that was
included in the transaction price from the original contract is
allocated to the remaining performance obligations (PCS and a material
right). If the conversion option is exercised, the amount allocated to
the material right plus any incremental fee paid would generally be
recognized over the remaining term of the SaaS (and the PCS for any
licenses that are not converted).
In Example 12-25,
C will recognize revenue of $2.4 million ($8,000 on-premise software
license stand-alone selling price × 100 seats × 3 years) on January 1,
20X0, for the software license and $200,000 ($2,000 PCS stand-alone
selling price × 100 seats × 1 year) for PCS ratably over 20X0. When the
contract is modified on January 1, 20X1, C has a contract liability
related to PCS of $400,000. Entity C will allocate that amount to the
remaining PCS and the material right on the basis of their relative
stand-alone selling prices. The material right’s stand-alone selling
price would be estimated as the $10,000 per seat per year discount
($11,000 SaaS stand-alone selling price − $1,000 incremental fee to be
paid), adjusted for the likelihood that the option will be exercised. We
believe that it would also be acceptable for C to estimate the
stand-alone selling price of the PCS by applying a similar adjustment
for the likelihood that the option will be exercised (which could
truncate the term of the PCS).
Assume that C determines that the relative stand-alone selling price
allocation of the transaction price results in allocations to the PCS
for 20X1, the PCS for 20X2, and the material right of $100,000, $50,000,
and $250,000, respectively.23 Entity C will recognize $100,000 for PCS ratably over 20X1. If the
customer elects to exercise the conversion right on 100 seats on January
1, 20X2, C would assess its policy for accounting for the exercise of an
option that includes a material right and apply either of the following:
-
Separate contract model — The remaining unrecognized revenue of $50,000 related to PCS is recognized immediately since PCS for all 100 seats is forfeited and therefore will not be provided in 20X2. Revenue of $350,000, which is calculated by adding the material right allocation of $250,000 and the incremental fee of $100,000 ($1,000 incremental fee × 100 seats), is recognized over the remaining one-year SaaS term.
-
Contract modification model — Revenue of $400,000, which is calculated by adding the remaining unrecognized revenue of $50,000 related to PCS, the material right allocation of $250,000, and the incremental fee of $100,000, is recognized over the remaining one-year SaaS term.
Alternative 3A may be less costly to implement than Alternative 3B below
because the stand-alone selling price of the material right is estimated
only upon contract modification and is not subsequently revised. In
addition, because the right of return model is not applied, the variable
consideration constraint would likewise not be applicable. Therefore,
revenue recognition could potentially be less volatile under the
prospective material right model than under the right of return model
discussed below.
12.6.4.3.2 Alternative 3B — Right of Return Model (Acceptable View)
Under this alternative, in a manner similar to that under Alternative 3A,
the contract modification is accounted for as a termination of the
existing contract and the creation of a new contract because the
modification does not solely add goods or services at their stand-alone
selling prices (i.e., a conversion right is added for no additional
consideration, which could result in the forfeiture of goods and
services, and any incremental fee to be paid for the SaaS is not at its
stand-alone selling price) and the remaining PCS is distinct. However,
unlike Alternative 3A, Alternative 3B treats any “unused” portion of the
on-premise software license as being effectively returned for a credit
that can be applied toward the purchase of the SaaS. Therefore, revenue
associated with the expected unused portion of the returned on-premise
software license is reversed. The amount of revenue reversed (i.e., the
credit associated with the potential unused portion of the returned
on-premise software license), together with any unrecognized revenue
that was included in the transaction price from the original contract,
is accounted for prospectively over the remaining two-year term. In
applying the right of return guidance, the entity would estimate and
recognize an adjustment to the transaction price (and reduce revenue)
upon contract modification to account for the potential conversion.24 The right of return would be accounted for as variable
consideration, subject to the constraint in ASC 606-10-32-11 and
32-12.25 The estimate of variable consideration associated with the right
of return would be reassessed at the end of each reporting period in
accordance with ASC 606-10-55-25 and 55-26, with changes in the estimate
recognized as an adjustment to revenue. If the conversion right is
exercised, the amount previously deferred as a liability26 plus the incremental fee paid would generally be recognized as
revenue over the remaining term of the SaaS (and the PCS for any
licenses that are not converted).
In Example 12-26,
C will recognize revenue of $2.4 million ($8,000 on-premise software
license stand-alone selling price × 100 seats × 3 years) on January 1,
20X0, for the software license and $200,000 ($2,000 PCS stand-alone
selling price × 100 seats × 1 year) for PCS ratably over 20X0. When the
contract is modified on January 1, 20X1, C would need to determine its
estimate of variable consideration and how much of that consideration,
if any, should be constrained. Assume that C determines that $1 million
of the original transaction price of $3 million is variable
consideration, which is calculated as ($8,000 on-premise software
license stand-alone selling price + $2,000 PCS stand-alone selling
price) × 100 seats × 1 year. In addition, assume that C estimates
variable consideration of $500,000 — calculated as ($8,000 on-premise
software license stand-alone selling price + $2,000 PCS stand-alone
selling price) × 50 seats × 1 year — and concludes that none of the
estimated variable consideration should be constrained.27 Therefore, C will reverse revenue of $400,000 ($8,000 on-premise
software license × 50 seats × 1 year) and reclassify $100,000 of the PCS
contract liability for the PCS expected to be forfeited ($2,000 PCS
stand-alone selling price × 50 seats × 1 year) for a total liability of
$500,000 for the credit the customer is expected to receive. Entity C
also has a remaining contract liability related to PCS of $300,000 and
recognizes $200,000 ($2,000 PCS stand-alone selling price × 100 seats ×
1 year) for PCS ratably over 20X1.
Assume that on December 31, 20X1, C revises its estimate of the liability
associated with the right of return to $1 million because it now expects
that the customer will convert all 100 seats to a SaaS arrangement.
Entity C will reverse an additional $400,000 of revenue for the
incremental 50 seats of on-premise software expected to be forfeited
($8,000 software license stand-alone selling price × 50 seats × 1 year)
and reclassify $100,000 of the remaining PCS contract liability for the
incremental PCS expected to be forfeited ($2,000 PCS stand-alone selling
price × 50 seats × 1 year) for a total increase in liability of $500,000
related to the credit expected to be granted to the customer. If the
customer elects to exercise the conversion right on 100 seats on January
1, 20X2, revenue of $1.1 million, which is calculated by adding the
liability of $1 million and the incremental fee of $100,000 ($1,000
incremental fee × 100 seats × 1 year), is recognized over the remaining
one-year SaaS term.
Because C’s initial estimate of the liability for the credit expected to
be granted to the customer was not sufficient, a significant amount of
revenue ultimately had to be reversed in a subsequent reporting period.
This example highlights the importance of critically evaluating how much
revenue should be constrained to ensure that it is probable that a
significant reversal in cumulative revenue recognized will not occur.
Given the risk of overestimating the amount of variable consideration to
which an entity can expect to be entitled for the on-premise software
license and PCS, we believe that many software entities, particularly
those that do not have sufficient historical data on conversion rates,
may find it challenging to determine an appropriate estimate of variable
consideration and constraint as required under Alternative 3B.
12.6.4.3.3 Tabular Summary of Alternatives 3A and 3B
The following table summarizes the timing
of revenue recognition under Alternatives 3A and 3B:
12.6.4.4 Initial Contract Includes Cloud Mixing Rights With a Cap
The example below illustrates an initial contract that gives the customer the
right to use nonexclusive licensed software on both an on-premise basis and
a cloud basis, subject to a cap on the total number of seats.
Example 12-27
On January 1, 20X0, Entity D enters into a
noncancelable two-year contract with a customer for
an up-front fee of $1 million to provide 1,000
nonexclusive software licenses. Under the terms of
the contract, the customer has an option to deploy
each of the 1,000 licenses as either on-premise
software or SaaS throughout the two-year license
term. That is, the customer can use any mix of
on-premise software and SaaS at any point during the
license term as long as the number of licenses used
does not exceed 1,000 seats. The on-premise software
license and the SaaS (1) are each fully functional
on their own and (2) provide the same functionality
and features (other than D’s hosting of the SaaS).
At contract inception, the customer decides to use
600 licenses as on-premise software and 400 licenses
as SaaS. Six months later, the customer decides to
use 500 licenses as on-premise software and 500
licenses as SaaS.
We believe that D may reasonably conclude that it has
promised to (1) provide the right to use on-premise
software and (2) stand ready to provide SaaS (i.e.,
to host the software license). Since each of the
promises is likely to be distinct, there are two
performance obligations to which the $1 million fee
should be allocated on a relative stand-alone
selling price basis. We believe that it would be
acceptable for D to estimate the stand-alone selling
price of each performance obligation by considering
the expected mix of on-premise software and SaaS.
The stand-alone selling prices are determined at
contract inception and should not be subsequently
revised regardless of whether the mix of on-premise
software and SaaS changes after the initial
estimate. Consideration allocated to the on-premise
software would be recognized once control of the
license is transferred to the customer. In addition,
since the performance obligation to provide SaaS is
satisfied over time, consideration allocated to this
performance obligation would be recognized as
revenue over the two-year contract term (i.e., the
period over which D is required to stand ready to
provide SaaS).
Footnotes
10
The alternatives outlined in this section are
premised on the assumption that the entity does not have an implied
obligation to provide PCS during the lapse period.
11
In this instance, it is assumed that the SaaS
arrangement is accounted for as a service contract because the customer
does not have the ability to take possession of the underlying software
on an on-premise basis in accordance with the requirements of ASC
985-20-15-5.
12
This alternative view is consistent with the accounting for
on-premise term-based software licenses that enable the customer
to terminate the license agreement without penalty. For example,
if a customer paid for a one-year on-premise term-based software
license but had the ability to cancel the arrangement for a pro
rata refund with 30 days’ notice, the term of the initial
arrangement would be 30 days, with optional renewals thereafter.
In those circumstances, the right of return guidance would not
be applied.
13
While the material right’s stand-alone selling
price could be adjusted for any discount the customer could
receive without exercising the option, this example assumes that
the customer could not receive a discount without exercising the
option.
14
The allocation of the transaction price based on relative
stand-alone selling price is included for illustrative purposes
only and uses simplistic assumptions; judgment will be required
to determine stand-alone selling prices in this and similar fact
patterns.
15
The variable consideration resulting from the right of return
would generally be estimated on the basis of the transaction
price allocated to the on-premise software and related PCS and
the amount of that allocated transaction price that is expected
to be refunded as a credit to the SaaS arrangement (i.e., the
pro rata portion of the on-premise software and related PCS that
is “unused”). If the credit plus any incremental fee required to
convert to the SaaS arrangement is less than the stand-alone
selling price of the SaaS, the entity may need to consider
whether a material right has also been granted.
16
Under ASC 606-10-32-11, an entity includes variable consideration
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.”
17
A liability for a return right is typically recognized as a
refund liability in accordance with ASC 606-10-55-23(b).
However, we believe that if an entity’s contract with a customer
is noncancelable and consideration therefore would not be
refunded to the customer, it would be acceptable to recognize
the liability as a contract liability (e.g., deferred revenue)
for the entity’s expected performance associated with a SaaS
arrangement.
18
The amount of variable consideration to include
in the transaction price is provided for illustrative purposes
only and uses simplistic assumptions; judgment will be required
to estimate variable consideration and the related constraint in
this and similar fact patterns.
19
Note that if an entity’s
contract does not contain a cloud conversion right
at contract inception, a practice of allowing
customers to convert their on-premise software
license to a SaaS arrangement may create an
implied right that is similar to the explicit
right provided to the customer in Example 12-24.
Significant judgment will be required to determine
when an implied right is created in these
circumstances.
20
Entity B would generally allocate the $125,000
between PCS and the SaaS on the basis of their relative
stand-alone selling prices if required to do so for presentation
or disclosure purposes. However, because both PCS and the SaaS
are stand-ready obligations that are recognized ratably over the
same period, the $125,000 was not allocated between the two
services for purposes of this illustration.
21
Entity B would generally allocate the $325,000
between PCS and the SaaS on the basis of their relative
stand-alone selling prices if required to do so for presentation
or disclosure purposes. However, because both PCS and the SaaS
are stand-ready obligations that are recognized ratably over the
same period, the $325,000 was not allocated between the two
services for purposes of this illustration.
22
See footnote 19.
23
See footnote 14.
24
See footnote 15.
25
See footnote 16.
26
See footnote 17.
27
See footnote 18.
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:
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View 1 — The sales- or usage-based royalty exception in ASC 606-10-55-65 is applicable.
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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.