Entities often buy or sell licenses of intellectual property (“IP”)—items such as patents, software, music, and scientific compounds. These contracts are common in industries such as technology, entertainment and media, pharmaceuticals and life sciences, and retail and consumer.
ASC 606 Revenue from Contracts with Customers (ASC 606) provides accounting guidance for the licensing of IP. In this article, we review that guidance and provide practical examples of its application. The accounting for sales- and usage-based royalties from IP licenses represents an important departure from the primary guidance on IP licensing and is not addressed in this article. For more information, please see the RevenueHub article Sales- and Usage-Based Royalties.
To properly account for IP licenses under ASC 606, entities must analyze the following: (1) whether the transaction represents a sale or licensing of IP; (2) whether the IP is a distinct performance obligation; (3) the nature of the license—functional or symbolic; and (4) the timing of recognition based on the nature of the license.
Sale Versus Licensing Transactions
The implementation guidance provided in ASC 606-10-55-54 through 55-64A applies only to the licensing of IP and not to the sale of IP. Accordingly, entities must determine if relevant transactions involve the sale or the license of IP. This analysis should be relatively straightforward because licenses transfer rights to IP, while sales transfer ownership. Sales of IP are accounted for using the general revenue recognition model if they represent a sale to a customer (The Five-Step Method) instead of the licensing guidance described further below.
Distinct Performance Obligations
Licenses of IP are often transferred with other goods or services in a contract. Therefore, entities must determine if a license of IP is a distinct (separate) performance obligation in accordance with ASC 606-10-25-18 through 25-22. This means that the IP must be (1) capable of being distinct and (2) distinct within the context of the contract. The licensing guidance provides two examples of when a license is not distinct from the other goods or services in a contract:
- When the license forms a component key to the functionality of a tangible good (e.g. machinery with integral embedded software).
- When the license is required for a customer to benefit from a related service (e.g. web hosting arrangements for software).
If a license is deemed not to be distinct during this analysis, the license is combined with the other goods or services and the combined performance obligation is accounted for using the general revenue recognition model (the nature of IP, discussed next, should still be considered during step 5 of the general revenue recognition model). Conversely, if the license is distinct, then it is a separate performance obligation. If the license is regarded as a separate performance obligation, entities must determine the nature of the license to assess the timing of revenue recognition.
Assertio Therapeutics (2019 SEC Correspondence): License of IP That Is Not Distinct
Background and Transaction Overview
Assertio Therapeutics (Assertio) discussed and analyzed an agreement with another pharmaceutical company (Collegium) in its correspondence with the SEC (January 2019 Letter). As part of the agreement, Assertio “granted to Collegium an exclusive licensed right to commercialize NUCYNTA (i.e. promote, distribute and sell) over the license period (the License).”
Assertio also agreed to provide certain services (Facilitation Services), including “to arrange for the supply of NUCYNTA products by the Company’s existing contract manufacturing organizations (CMOs).” It “agreed to facilitate or arrange for supply from the Company’s CMOs based on purchase orders received from Collegium.”
Analysis of Whether the License and the Services Are Distinct
Assertio considered two main factors in its evaluation:
- Manufacturing rights. The agreement does not grant to Collegium a license to manufacture NUCYNTA. Assertio
- exclusively controls the intellectual property underlying the NUCYNTA products for the United States market.
- retains responsibility for facilitating NUCYNTA product supply through its CMOs.
- exclusively maintains all CMO contractual relationships.
As a result, Collegium’s right to commercialize NUCYNTA is inherently dependent upon the facilitation services.
- Regulatory factors. Tapentadol, the active pharmaceutical ingredient in NUCYNTA, is classified by the United States Drug Enforcement Agency (“DEA”) as a Schedule II controlled substance and is subject to numerous restrictions as to its manufacture and distribution. Only the CMOs are registered with the DEA and authorized to manufacture product containing tapentadol. There is strong interdependency between the license and the facilitation services because of the following factors:
- Collegium is contractually required to use the facilitation services to arrange for product supply.
- Tapentadol is a Schedule II controlled substance for which manufacturing arrangements are not easily transferred or bypassed.
Conclusion
Assertio concluded that the two are not distinct, explaining that
it was, and continues to be, necessary for [Assertio] to provide the Facilitation Services to facilitate or arrange for product supply from the CMOs based on purchase orders received from Collegium (akin to re-invoicing services). These Facilitation Services are administrative in nature but necessary for the commercialization right to have utility to Collegium. Given these factors, the Company concluded that the License and the Facilitation Services are not distinct from one another.
Starbucks (2019 SEC Correspondence): License of IP That Is Distinct
Background and Transaction Overview
Starbucks’ correspondence with the SEC provides a thorough analysis of its licensing arrangements (May 2019 Letter). Starbucks generally includes three distinct, bundled performance obligations as part of its licensed store arrangements:
- License – License to develop and operate individual Starbucks store(s)
- Architectural/Design Obligation – Site selection and development/review of plans and designs (pre-opening services)
- Training – Development and operational training for the licensee predominately prior to the store opening
Analysis of Whether the License and the Services Are Distinct
The SEC pressed Starbucks, asking for “the judgments made by management in determining pre-opening services (performance obligations 2 and 3 above) are distinct from the license performance obligation.”
Starbucks responded with the following commentary:
We consider goods or services to be distinct if the customer receives benefits from the goods or services on their own or with other resources that are readily available and if our promise to transfer the goods or services to the customer can be separately identified and distinguished from other promises in the contract (ASC 606-10-25-19). With respect to pre-opening services, these services are rendered before the license is transferred, and the utility of the pre-opening services is not enhanced by the license performance obligation, as the knowledge and outputs from these services are retained by the licensee without the support and maintenance of the license.
At the point of store opening, the customer is provided a set of business and industry insights and knowledge that is separate and distinct from the license. As such, we concluded that the customer can benefit from the services on their own without access to the license. We also believe that our promise to deliver the pre-opening services is separately identifiable from the transfer of the license. Access to the license does not significantly affect the licensee’s ability to use and benefit from the pre-opening services, as the licensee has retained the value from our pre-opening services.
Additionally, provision of the license does not result in significant modification or customization of the pre-opening services the licensee has already received.
Lastly, the license and pre-opening services are not highly interdependent or interrelated because we sell access to our marks and licenses independent of any promise to provide pre-opening services.
Conclusion
Starbucks concluded that the three performance obligations, including the license, are distinct. Starbucks also agreed to include the following disclosure in future filings:
We consider pre-opening services, including site evaluation and selection, store architectural/design and development and operational training, to be performance obligations that are separate from the license to operate under the Starbucks brand as these pre-opening services provide distinct value to our licensees, including business and industry insight and knowledge that transfer values apart from the license.
The Nature of the License
As noted above, the nature of a license affects the timing of revenue recognition. This is because a license provides a customer either the right to use the IP as it exists at the start of the licensing period or the right to access the IP over the license period. These two uses represent different types of licenses of IP: Functional and symbolic. The two types are based on the standalone functionality and the level of continued support or maintenance of the licensed IP.
Functional IP
This type of IP is distinguished by the existence of a significant standalone functionality, such as performing a task, processing a transaction, or airing creative works. In addition, the functionality must be a substantial portion of the IP’s utility—its ability to provide benefit or value (ASC 606-10-55-59a). The promise to deliver IP in this type of license does not depend on continued support and maintenance. Therefore, the key promise being delivered is the utility of a standalone functionality as it exists at the license start date.
Since the significant standalone functionality of functional IP is delivered immediately, these licenses provide a customer the right to use the IP. As such, revenue from functional IP is generally recognized at a point in time (when the license period commences). However, some functional IP may still provide rights not only to use, but to access IP, if the following two criteria are met (ASC 606-10-55-62):
- 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.
- The customer is contractually or practically required to use the updated intellectual property resulting from the activities in criterion (a).
The purpose of the two criteria is to maintain consistency with the conceptual underpinnings of the licensing guidance of ASC 606. Specifically, some functional IP may be affected by the ongoing activities of a licensor and the licensee may be required to use the updated IP. In this way, the licensor is not providing a right to use the IP at a point in time but is rather providing a right to access the IP over time. Accordingly, when both criteria are met, revenue is recognized over time. The FASB notes that because the updates to IP often transfer additional promised goods or services, the criteria apply only in some situations.
Example 1: Revenue Recognized at a Point in Time for Functional IP
Company A is a pharmaceutical company that routinely licenses its internally developed drug formulas to pharmaceutical manufacturers. Recently, Company A licensed a new drug to Customer B. The license provides Customer B with rights to manufacture and sell the new drug for a period of three years. Company A’s continuing operations do not affect the licensed drug formula.
Analysis
In this case, the license is for functional IP. The license to the drug formula gives Customer B the ability to manufacture the proprietary drug (i.e., a significant standalone functionality). Further, the functional IP provides a right to use IP because Company A’s continuing activities do not alter the functionality of the drug formula. Therefore, neither criteria of ASC 606-10-55-62 are met. Revenue will be recognized at a point in time.
Example 2: Revenue Recognized over Time for Functional IP
Company G is a software company that provides word processing software to end consumers. Company G also provides if-and-when type updates to the software. These updates, due to their integrated nature with the software licenses, are not distinct from the software license. Thus, the license and the updates are determined to be a single performance obligation. Licensees are not contractually required to apply the updates to the original software license even when the updates become available; however, the significant functionality of the software is limited without the updates.
Analysis
In this case, the license is for functional IP. This is because the software’s significant standalone functionality is to provide customers the ability to perform a task, such as writing a document. However, because the updates alter the standalone functionality of the IP and licensees are practically required to apply the updates (i.e., both criteria of ASC 606-10-55-62 are met), this license provides a right to access the software and revenue will be recognized over time.
W.R. Grace & Co. (2018 SEC Correspondence): Example of a License with Functional IP
In a letter to W.R. Grace (Grace), the SEC asked the company to describe whether the technology “licenses are functional or symbolic and explain the basis for your determination” (August 2018 Letter). Grace explained that “[the] UNIPOL® polypropylene technology licenses are functional,” citing three main reasons:
- The license enables the licensee to design or have designed, construct or have constructed, and maintain the polypropylene manufacturing reactor unit.
- The license enables the licensee to make licensed polypropylene resins up to a certain capacity.
- The license enables the licensee to use and sell the licensed polypropylene resins manufactured in the newly constructed polypropylene manufacturing reactor unit.
Based on the above facts, Grace concluded that the IP license has enough standalone functionality to be considered functional rather than symbolic.
Symbolic IP
ASC 606 defines symbolic IP as being not functional IP, meaning that it does not have a significant standalone functionality. The utility provided to the customer comes from the licensor’s past or ongoing activities, including its ordinary business activities. Because the IP’s utility is dependent on the licensor’s ongoing activities (or from abstaining from certain activities), the license is considered to be providing a right to access IP over the license term. Therefore, all symbolic IP licenses provide a right to access IP and revenue from such licenses is recognized over time. Common types of symbolic IP include brands, logos, and trade names.
Example 3: Revenue Recognized over Time for Symbolic IP
Company L is a management company that owns a number of semi-professional sports teams in small markets across the United States. Company L routinely licenses its logos to local businesses to be used for creating and selling team merchandise. Recently, Company L licensed the logo of the Rochester Grahams to Customer M.
Analysis
In this case, the license is for a symbolic IP. This is because the IP does not have a standalone functionality; that is, the utility comes from Company L’s past and continuing activities. Such activities include continuing to maintain a team, keeping the team in the Rochester area, etc. Therefore, the license provides a right to access IP and revenue is recognized over time.
Starbucks (2019 SEC Correspondence): Example of a License with Symbolic IP
Starbucks entered into a licensing agreement with Nestlé, allowing Nestle to use its trademarks. Nestlé made an upfront payment of $7 billion as part of the transaction. In its correspondence with Starbucks, the SEC asked why Starbucks believes “recognition of the upfront payment of $7 billion from Nestlé on a straight-line basis over the estimated economic life of the arrangement provides a faithful depiction of the transfer the promises in licensing arrangement” (May 2019 Letter).
As part of its response, Starbucks explained that the transaction “represents a prepayment for using our brands, trademarks, and trade names during the contractual term of the arrangement. Therefore, we consider that the performance obligation is a promise to a right to access our intellectual property.” Starbucks then explained its basis for treating the license of IP as a symbolic license, found in ASC 606-10-55-59:
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.
Starbucks made concluded the following:
As a consumer products company, our enterprise value is largely derived from our brand, trade logo, and trade names. As such, we will support, maintain, and protect these symbolic intellectual properties for the foreseeable future and certainly during the term of our arrangement with Nestlé. From a customer’s perspective, Nestlé began accessing the rights to use our brand and trademarks since contract inception and is expected to continue to do so throughout the term of the arrangement in order to market the products effectively. As the vendor in this arrangement, Starbucks has a license performance obligation that includes continuously providing access to the licenses within the contractual territories. Furthermore, Starbucks’ obligation to maintain the brand is the same every period throughout the term, and therefore the ratable recognition pattern is reflective of how the Company satisfies its obligation, which is the same each period.
Timing of Recognition
The determination of the IP’s nature as being either a right to use or a right to access affects the timing of revenue recognition. Specifically, revenue from licenses of IP deemed to provide a right to use IP will be recognized at a point in time when control is transferred in accordance with ASC 606-10-25-30 (see RevenueHub article on Determining The Transfer Of Control). On the other hand, revenue from licenses of IP deemed to provide a right to access IP will be recognized over the license period (or its remaining economic life, if shorter). Such licenses will follow the revenue recognition over time guidance found in ASC 606-10-25-31 through 37 (see RevenueHub articles on Revenue Recognition Over Time and Input Versus Output Methods).
Consistent with ASC 606’s approach to revenue recognition, revenue from licenses of IP should faithfully reflect the transfer of control to the customer. However, when implementing ASC 606 to licenses of IP, revenue cannot be recognized before both (1) the licensor makes the IP available to the customer and (2) the license period begins (ASC 606-10-55-58C). This also applies to instances of license renewal and term extension. For example, when a customer renews a license, the entity may not recognize revenue from the renewal until the start date of the renewed license.
Commvault Systems (2017 SEC Correspondence): Determining the Point at Which Control of Licensed IP Transfers
Background and Transaction Overview
Commvault Systems, Inc. (Commvault) provides data protection and data management software. To access this product, customers must use Commvault’s software license keys.
Analysis of When the Performance Obligation Is Satisfied
The SEC asked Commvault to explain “whether the performance obligation of providing software licenses is satisfied upon shipment or when the software is made available for download.” The SEC also wanted to know how Commvault considered ASC 606-10-55-58C “in determining the point in time at which you recognize revenue” (October 2017 Letter).
Commvault explained that it provides two things when transferring the software license to customers:
- Email notification of access to a secure website for the software to be downloaded
- Email correspondence with license keys to be applied to the downloaded software
Commvault also determined that transfer of control occurs when the software key is delivered—even if the customer has not installed the software yet—based on the following facts:
- Commvault has a present right to payment
- The customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from the software
- The customer has the significant risks and rewards of ownership of the asset
- The customer has accepted the software
- Commvault has provided (or otherwise made available) the software to the customer
- The perpetual license to use the software starts when the software key is delivered
Conclusion
Commvault concluded that
the period during which the customer is able to use and benefit from its right to access or its right to use the software begins once the Company has provided access to the secure website for the software to be downloaded and the license keys to be applied to the downloaded software have been sent. For subscription licenses, the Company does not recognize software license revenue before the beginning of the software license period even if it transfers the software code before the start of the license period or the customer has a copy of the software from a previous transaction.
The following flowchart, adapted from ASC 606-10-55-63A and KPMG’s Revenue Issues In-Depth: Second Edition, illustrates the process described above:
Additional Considerations
License contracts for IP often contain provisions that explicitly or implicitly define the attributes of a license (ASC 606-10-55-64). For example, contracts may limit IP to a certain geography and/or time. Provisions that define the attributes of a license are not considered in determining whether a license of IP provides a right to use or a right to access IP. However, in some cases, explicit or implicit provisions may create promises to transfer additional licenses. In these cases, entities will need to evaluate each license separately to determine its nature.
Example 4: Geographical Provision Treated as a Single License
Company S is a global media company with a highly recognizable brand. Recently, Company S licensed its logo to Customer T to be used on children’s hats sold in North America and Europe. The contract includes a provision granting Customer T the right to use the logo in both North America and Europe starting December 1, 20X1.
Analysis
In this case, the geographical provisions are merely attributes of the license that do not create additional licenses. Therefore, this would be treated as one license in applying the licensing guidance.
Example 5: Geographical Provision Creating Additional Licenses
Assume the same facts as Example 4 except that the contract includes a provision granting Customer T the right to use the logo in North America starting December 1, 20X1 and in Europe starting in March 1, 20X2.
Analysis
In this case, the separate geographical and license start date provisions create additional licenses. This is because the rights to use the logo in North America have a discrete term from the rights to use the logo in Europe. Therefore, these would be treated as two licenses in applying the licensing guidance.
Concerning contract provisions that may create additional licenses, ASC 606-10-55-64A notes that guarantees validating patents or promising to defend patents from unauthorized use do not affect the nature of the license of IP.
Conclusion
Concerning contract provisions that may create additional licenses, ASC 606-10-55-64A notes that guarantees validating patents or promising to defend patents from unauthorized use do not affect the nature of the license of IP.
Resources Consulted
- ASC 606-10-55-54 through 55-64A
- ASU 2014-09 BC409B
- ASU 2016-10 BC35 through BC69
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. 8.1 – 8.5 “Licensing”
