Entities may buy or sell licenses of intellectual property (“IP”)—items such as patents, software, music, and scientific compounds—to further the business purposes of the entity. 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 guidance for the licensing of intellectual property. This paper outlines licensing under ASC 606 and compares this accounting to ASC 605. The accounting for sales- and usage-based royalties from the licensing of intellectual property is not addressed. For the accounting on this subject, please see the RevenueHub article on Sales- and Usage-Based Royalties.
To properly account for licenses of IP in accordance with ASC 606, practitioners must complete a sequence of analyses. These analyses include the following and are discussed below: (1) sale versus licensing transactions; (2) distinct performance obligations; (3) the nature of the license; 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 the sale of such assets. Accordingly, entities must determine if relevant transactions involve the sale or license of IP. This analysis should be relatively straight forward as licenses transfer rights to IP, while sales transfer ownership. Sales of IP are accounted for using the general revenue recognition model (five-step process) 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 performance obligation in accordance with ASC 606-10-25-18 through 25-22; that is, if the license is (1) capable of being distinct and (2) distinct within the context of the contract. (For more on distinct performance obligations, see our article Distinct within the Context of the Contract.) The licensing guidance further 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 to not 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, practitioners must determine the nature of the license to assess the timing of revenue recognition.
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. ASC 606 provides two types of licenses. The purpose of classifying licenses by type is to assist practitioners in determining if an entity is providing rights to access or rights to use IP. 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 (e.g. performing a task, processing a transaction, or airing creative works). In addition, the functionality must be a substantial portion of the IP’s utility (that is, its ability to provide benefit or value) (ASC 606-10-55-59a). This type of license assumes that continued support and maintenance are not part of the promise in delivering the IP. Therefore, the key promise being delivered is the utility of a standalone functionality as it exists at the license start date.
Because 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 is delivered). However, certain functional IP may still provide rights to access IP if the following two 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”
- “The customer is contractually or practically required to use the updated intellectual property resulting from the activities in criterion (a)” (ASC 606-10-55-62)
The purpose of the above 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 is 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. Financial Accounting Standards Board (“FASB” or “the Board”) notes that because the updates to IP often transfer additional promised goods or services, the criteria apply only in some situations.
Company A is 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. This is because 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.
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.
Symbolic IP. ASC 606 defines symbolic IP as being not functional IP, meaning that it does not have a significant standalone functionality. In this way, 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, trade names, etc.
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.
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 utility 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.
The following flowchart, adapted from ASC 606-10-55-63A and KPMG’s Revenue Issues In-Depth: Second Edition, illustrates the process described above:
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.
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.
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.
In addition to considering contract provisions that may create additional licenses, ASC 606-10-55-64A notes that guarantees that validate patents or promise to defend patents from unauthorized use do not affect the nature of the license of IP.
Comparison to 605
Licenses of IP are treated in a number of ways under ASC 605 due to various industry specific guidance (e.g. film, software). However, ASC 605 does not provide general guidance related to licenses of IP. In contrast, ASC 606 replaces industry-specific guidance with general guidance applicable to licenses of IP in all industries. The removal of industry-specific guidance will cause significant changes to the accounting for licenses of IP in certain industries. For example, franchising agreements will generally be accounted for as rights to access with upfront payments being recognized over time (unless the payments relate to a separate performance obligation distinct from the IP).
Accounting for licenses of IP may also be impacted by the added distinct criterion of ASC 606 (i.e. distinct within the context of the contract). The additional criterion may require certain non-license goods or services to be bundled with the license of IP that would not be bundled under ASC 605. Additionally, the classification types of IP (functional or symbolic) could result in further changes from ASC 605, as these classification types assist in determining the nature of the licensed IP. In the absence of general guidance under ASC 605, accounting for licenses of IP is an area with much diversity in practice and entities’ determination of the nature of licensed IP may differ from the classifications provided in ASC 606 (KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. 8.3).
Further considerations should be made for sales- and usage-based royalties in determining the transaction price, as such royalties are excluded from the transaction price until the sale or usage occurs (please see our article on Sales- and Usage-Based Royalties).
Accounting for the licensing of IP requires a sequence of analyses that includes determining if licenses are distinct from non-license goods or services in a contract and the nature of the IP. Distinct licenses may provide customers the right to use or the right to access IP depending on the nature of the IP. Revenue from licenses that provide a right to use IP is recognized at a point in time while revenue is recognized over time for licenses that provide a right to access IP. ASC 606 eliminates industry specific guidance for licenses under ASC 605, which is likely to change the accounting for licensing contracts.