Sales- and usage-based royalties are variable consideration received by an entity as part of a licensing agreement, usually for intellectual property (IP), technology, or other similar intangible-type assets that the entity has developed. As described in Accounting Standards Codification (ASC) 606-10-32-6, sales- and usage-based royalty consideration is variable because the payment of royalties is contingent upon the sales or usage of the licensed IP. For most contracts, variable consideration is calculated based on the expected-value method or the most-likely-amount method. For more information on these methods, see Allocating Variable Consideration.
Many royalty arrangements are treated the same as standard variable consideration. However, sales- and usage-based royalty agreements based on a license of IP are exceptions to the typical guidance for estimating variable consideration (ASC 606-10-32-11 through 32-14). The Financial Accounting Standards Board (FASB) removed these royalty agreements from the variable consideration guidance because consideration received under these agreements depends solely on the performance of the licensee and is generally independent of the licensor’s performance. The FASB guidance incorporates the uncertain and unpredictable nature of these royalties into the revenue recognition process. This article discusses both how to determine if a royalty agreement fits within this exception and how to account for the royalties if they do. A flowchart is also provided at the end of the article to visually summarize the entire process for recognizing sales- and usage-based royalties.
Criteria For The Sales- And Usage-Based Royalty Exception in ASC 606
In order for a royalty to qualify for the exception, it must meet both criteria:
- A royalty must be based strictly on sales or usage by the licensee. A royalty based on any other fact pattern, such as volume, fixed fees, or milestones achieved by the licensee, may not qualify for the exception.
- A license of intellectual property (IP) must be the sole or predominant item to which a royalty relates. A royalty that serves as consideration for any other type of licensing arrangement does not qualify for the exception.
Criterion 1: Sales- and Usage-Based Royalties.
Generally, consideration in a sales-based royalty agreement is contingent upon and paid out as the licensee sells goods or services that utilize the licensed IP. The focus in sales-based royalties is on sale of a final product. In many cases, a sales-based royalty is paid out as a portion or percentage of sales revenue generated using the licensed IP.
A usage-based royalty is consideration paid for each use of IP. Generally, usage-based royalties are focused on the licensee’s use of IP in production or operations rather than the licensee’s end-sales or other benefits derived from the license of IP. Intuitively, usage-based royalties are paid as the licensee uses the IP for its purposes, regardless of the benefits to the licensee that result.
Criterion 2: Royalties for Licenses of IP.
ASC 606-10-55-65A limits the exception to apply to sales- and usage-based royalties that are solely or predominantly related to a license of intellectual property. The license is the predominant item of a royalty when the entity can reasonably expect that the customer places more value on the license than the other items included in the royalty. Although not specifically defined in the new standard, intellectual property is generally known to be the product of the creativity or intellect of an individual or company. Intellectual property includes intangible assets such as patents, copyrights, trademarks, and trade secrets.
Situations may arise in which royalty consideration relates partially to a license of IP and partially to other promised goods or services. For example, software licenses are frequently sold packaged with maintenance, consulting, or training services. ASC 606-10-55-65A indicates that as long as the license of IP is the predominant item within the arrangement, the exception covers the entire royalty stream. If the license of IP is not the predominant item, then the exception does not apply. Therefore, ASC 606 takes an all-or-nothing approach.
In certain circumstances, licenses of IP containing a royalty based on sales or usage are determined to not be distinct and are bundled together with other promised goods or services as one performance obligation. This bundling can occur when the license of IP is closely tied to a promised good or service. For example, a software licensing agreement may include installation services and training for the licensed software, which may be bundled together. However, regardless of the distinctness of a license for IP, the exception for sales- and usage-based royalties is still applicable.
Whether a license gives the licensee the right to use or the right to access licensed IP is important for estimating variable consideration. However, this distinction does not have any bearing on the applicability of the exception or the timing of revenue recognition for sales- or usage-based royalties that fall under the purview of the exception.
Recognizing Revenue Under The Sales- And Usage-Based Royalty Exception
After determining that a royalty qualifies for the exception, an entity must assign and subsequently recognize revenue accordingly. Because of the difficulties and issues associated with estimating sales- and usage-based royalties, these royalties are merely assigned (not allocated) to the appropriate promised goods or services. In many circumstances, royalties are assigned solely to the license of IP. Once the royalty is realized through the subsequent usage or sale of IP, it is added to the transaction price and allocated to its assigned promised goods or services. In situations where a royalty relates to more than one promised good or service, a common way to assign the royalty is to assign a percentage of the royalty to each applicable individual promised good or service. The overarching principle for assigning or allocating variable consideration is stated in ASC 606-10-32-28 as follows:
The objective when allocating the transaction price is for an entity to [assign and subsequently] allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer
Once a sales- or usage-based royalty is properly assigned and allocated, ASC 606-10-55-65 outlines two criteria that must be met before revenue recognition can occur. Revenue may be recognized on sales- and usage-based royalties only when both of the following events have occurred:
- The subsequent sale or usage relating to the licensed IP occurs
- Whole (or partial) satisfaction of the performance obligation to which all (or some) of the sales- or usage-based royalty has been allocated
By preventing revenue recognition on sales- or usage-based royalties until the later of these two criteria have been met, the FASB has removed the uncertainty in estimating these royalties. Ultimately, these criteria were designed to protect the relevance and quality of financial statements information.
Sometimes, an arrangement involves milestone payments or a minimum guarantee. Milestone payments are forms of variable consideration that are paid if a target is reached. If milestone payments are based on sales or usage, the exception applies. However, a minimum guarantee, which is an amount a company must pay even if it doesn’t reach a certain level of sales or usage, would have to be accounted for separately because that portion is not a sales- or usage-based royalty.
Under the revenue recognition standard, sales- and usage-based royalties for licenses of IP are an exception to the standard guidance on estimating the transaction price for variable consideration. The guidance for this exception is found in ASC 606-10-55-65 through 55-65B, and is only applicable to licenses of IP where accompanying royalties are based on sales or use. Sometimes sales- or usage-based royalties can be bundled into performance obligations with other promised goods or services.
In other circumstances, these royalties may relate to other promised goods or services in addition to the license of IP. In these situations, ASC 606-10-55-65A clarifies that if the license of IP is the predominant item in the royalty arrangement, then the exception applies to the entire revenue stream. The royalty agreement is subsequently allocated to the performance obligations, although no amount can be added to the transaction price until the sales or usage occurs. At the later of the subsequent sales, usage, or satisfaction (whole or partial) of the performance obligation to which the royalty belongs (regardless of distinctness), revenue can be recognized. There are many circumstances in which recognition of sales- or usage-based royalties may be complicated and require judgment; however, readers can utilize the flowchart below to assist them in making these judgments.