The licensing of intellectual property (IP) is a common practice in the media and entertainment industry. For example, popular media companies such as Disney, Sony, and DreamWorks own thousands of valuable trademarks, logos, character images, etc. that can be licensed to external companies. Often, these licensing contracts include sales- or usage-based royalties. In these contracts, licensors may require a minimum guaranteed amount to limit the downside of the variable returns promised. The following case will analyze a hypothetical licensing contract for IP with sales-based royalties and a minimum guarantee under Accounting Standards Codification (ASC) 606: Revenue from Contracts with Customers.
Case Study Background
Fabled Productions (FP) is a media and entertainment company headquartered in Los Angeles, California. The company has a long history of producing successful television programs and blockbuster movies. In addition to producing television programs and films, FP frequently licenses trade names, logos, and other trademarks to various companies.
Recently, FP entered into a five-year licensing arrangement with World of Pinball Wizardry (WPW), a manufacturer of high-end pinball machines. The contract agreement provides WPW with the rights to design and manufacture pinball machines emblazoned with trade names and logos from one of FP’s successful and longstanding television programs named Life and Limb. Life and Limb is a game show that FP first began producing about 20 years ago. FP still produces the program and intends to continue production for at least seven more years.
In return for providing WPW with rights to certain trademarks, FP will receive a $500 royalty on each Life and Limb pinball machine WPW sells. WPW plans to manufacture the machines in response to orders as the demand for this novelty pinball machine is uncertain; however, WPW forecasts total sales during the contract period will range from 500 units to 1,200 units, with the expected sales volume of 950 units. The expected volume was determined using a probability-weighted average. To hedge against this uncertainty, FP required a minimum guarantee of $300,000 in the licensing contract, equivalent to 600 units sold. Royalty payments will be made from WPW to FP at the end of each year. If necessary, the deficit between cumulative royalties and the minimum guarantee will be settled at the end of the contract.
For reference, here is a summary of the relevant contract details:
- License pertains only to trademarks from Life and Limb television program
- License term of five-years
- Set royalty fee of $500 on each Life and Limb pinball machine sold
- Demand uncertain, between 500 and 1,200 units
- Expected volume to be sold around 950 units
- Minimum guarantee of $300,000 in royalties
NOTE: Licensing contracts similar to the contract considered in this case (i.e. sales- or usage-based royalties with minimum guarantees) were the subject of the Transition Resource Group for Revenue Recognition (TRG) meeting held November 7, 2016. The TRG concluded that three common views or approaches to recognizing revenue for contracts like this case were acceptable. The analysis below follows View B considered by the TRG. An explanation of the other two approaches can be found in the section below titled “Alternative Approaches”. This section includes a comparison of the revenue patterns for each approach.
The following provides an analysis using the five-step method of ASC 606 to determine the proper revenue recognition given the above case facts:
Step One: Identify the contract with a customer
Identifying the contract in this case is relatively straightforward as the entities have formally agreed on the terms of the arrangement through an executed contract. Additionally, both parties are substantially committed to the contract and collectability is probable.
Step Two: Identify the performance obligations in the contract
In accordance with ASC 606-10-25-14, FP must assess any and all promises made to WPW to identify distinct performance obligations. In this case, the contract includes the licensing of IP. The licensing contract does not include any tangible goods or other services. Additionally, the contract gives WPW rights to IP without any provisions regarding geography or time that may be deemed distinct licenses for accounting purposes. Consequently, the rights granted to WPW for FP’s IP is the only performance obligation of the contract.
Step Three: Determine the transaction price
ASC 606 requires FP to determine the total consideration to which it is entitled or expects to receive from WPW. The total transaction consideration, or price, may include fixed and/or variable consideration, noncash consideration, financing components, etc. In this case, the sales- and usage-based royalties FP will receive based on Life and Limb pinball machines sold are variable in nature. However, the minimum guarantee included in the contract for $300,000 represents a fixed amount of consideration. Accordingly, FP will estimate the total amount of consideration it expects to receive from WPW considering both the fixed minimum guarantee and any royalties in excess of this amount. FP chooses to follow the “expected value” approach to estimate its total consideration (ASC 606-10-32-8a). Based on the probability-weighted estimate of 950 units sold, FP estimates the transaction price to be $475,000 (950 units x $500 per unit = $475,000).
Because of the minimum guarantee, this transaction price can be considered $300,000 of fixed consideration and $175,000 of variable consideration.
Step Four: Allocate the transaction price to the performance obligations in the contract
ASC 606 requires the transaction price be allocated to each distinct performance obligation in the contract based on standalone selling prices. Because this contract only has one performance obligation, the entire $475,000 will be allocated to this obligation.
Step Five: Recognize revenue when (or as) the entity satisfies a performance obligation
FP must recognize revenue as it satisfies its performance obligation either at a point in time or over time. Given the type of performance obligation included in this licensing contract, rights to IP, this case falls within the purview of the implementation guidance for licenses of IP in ASC 606-10-55-54 through 55-64A (For more on this topic, please see our article on Licenses for Intellectual Property). This specific guidance outlines the process for determining the nature of a license of IP as giving either rights to use IP or rights to access IP which will determine if the performance obligation is satisfied at a point in time (right to use) or over time (right to access).
To determine the nature of the license of IP, FP must first classify the IP as either functional or symbolic. Functional IP must have significant standalone functionality (i.e. the ability to be played, perform a task, etc.). In this case, the licensed trademarks do not have significant standalone functionality. The logos that FP is licensing to WPW do not have value separate from the activities of FP. The IP derives utility from FP’s past and future activities, in accordance with ASC 606-10-55-59. That is, the trademarks’ value comes from FP’s previous productions of Life and Limb and its plans to continue the program for several more years. Accordingly, the IP is considered symbolic IP and the license therefore provides a right to access the IP over the license term.
Because the license provides rights to access IP, the performance obligation is satisfied over time per ASC 606-10-55-58A. Therefore, FP must select a measure of progress that represents the satisfaction of its obligation to WPW over time. In this case, the rights to access IP occur evenly over the contract term. Thus, FP selects a time elapsed measure of progress that will result in even revenue recognition each year of the license term, or $95,000 per year ($475,000 / 5 years).
Typically, revenue is recognized as performance obligations are satisfied. However, ASC 606 alters this requirement for sales- and usage-based royalties from licenses of IP so that revenue is recognized at the later of (1) when the subsequent sale occurs (e.g., the sale of a pinball machine) and (2) when the performance obligation connected to the royalty has been satisfied. (For more on this topic, please see our article on Sales- and Usage-based Royalties.) Therefore, although the satisfaction of the performance obligation will occur evenly over the license period, sales- and usage-based royalty revenue can only be recognized as pinball machines are sold and give rise to royalties. This constraint applies only to revenue beyond the minimum guarantee amount of $300,000 (or 600 pinball machines) because only revenue beyond that minimum guarantee is dependent on sales. Even if no pinball machines were ever sold, the $300,000 would not be reversed. In contrast, revenue beyond the minimum guarantee is variable and is thus subject to the constraint.
Assume the pinball sales and royalties received from WPW over the five-year license were as follows:
|Cumulative Royalties Received||$60K||$145K||$260K||$340K||$475K|
Given the above royalties, revenue recognition would be as follows:
|Cumulative Royalties Received||$60K||$145K||$260K||$340K||$475K|
As shown above, $95,000 of revenue is recognized evenly during years 1 through 3. However, once cumulative revenue meets the minimum guarantee of $300,000, revenue is constrained. In year 4 for example, revenue is constrained to 680 units sold: 600 of which correspond to the minimum guarantee and 80 of which represent the additional units sold above 600 to this point in time. Note that cumulative royalties and cumulative revenue are equal in years 4 and 5 at $340K and $475K, respectively.
As mentioned above, the November 7, 2016, TRG meeting considered three specific alternative approaches to accounting for licensing contracts for symbolic IP with minimum guarantees. The TRG deemed each acceptable. View B from this meeting was detailed above. The following provides a summary of Views A and C as well as a comparison of the revenue patterns of each View for the case facts above:
Of the three alternative approaches, View A is the simplest approach to apply. Under View A, revenue is recognized in the amount of the royalties due in each period. Consequently, View A is only acceptable in cases when cumulative royalties are expected to exceed any minimum guarantee. Thus, the minimum guarantee is effectively ignored and royalties are recognized as if no minimum guarantee exists. Despite its simplicity, this approach has significant commercial drawbacks because new licensing arrangements may not have sufficient royalty reporting history on which to base estimates and licensee lead times may delay revenue.
Under View A, the license of symbolic IP is considered a series of distinct services in accordance with ASC 606-10-25-14b. Further, variable consideration is deemed specifically related to services provided in distinct service periods (i.e. royalties for year 1 relate to the distinct service period of year 1). View A also meets the allocation objective of ASC 606-10-32-28. Therefore, variable consideration can be allocated to specific periods. View A also applies the practical expedient included in ASC 606-10-55-18 as an output measure that allows an entity to “…recognize revenue in the amount to which [it] has a right to invoice.” Because royalties due, or the amount that the entity has a right to invoice, correlates directly to value delivered to the licensee, revenue will be recognized in the period the royalty is earned, in the amount of the royalty due.
View A does not conflict with the sales- and usage-based royalty constraint because revenue is not recognized until the underlying sale or usage has occurred.
View C is the most conservative approach considered by the TRG. Only the fixed minimum guarantee is recognized as revenue over the contract and variable consideration is not recognized until cumulative royalties exceed the minimum guarantee. This approach allows for more predictable revenue patterns and gives time for new arrangements to develop a royalty history on which to base estimates.
Proponents of this View argue that recognizing revenue for the variable portion of the contract, the amount that exceeds the minimum guarantee, before the minimum guarantee is reached violates the sales- and usage-based royalty constraint because the sale or usage has yet to occur. Accordingly, under View C, the minimum guarantee is fixed consideration recognized over the contract period using an appropriate measure of progress (the time elapsed measure of progress may be used for the case above) and royalties above the minimum guarantee will be allocated as variable consideration. Like View A, the license of symbolic IP is considered a series of distinct services and variable consideration can be allocated to distinct service periods. Therefore, once the cumulative royalties reach the minimum guarantee, variable consideration begins to be recognized in the period in which it is earned, in the amount above the minimum guarantee earned. Additionally, the minimum guarantee continues to be recognized in subsequent periods in accordance with the selected measure of progress.
The TRG determined that each alternative considered above is a reasonable interpretation of the revenue standard. The TRG also notes that other alternatives may be acceptable as long as these alternatives conform to ASC 606’s guidance on variable consideration allocation objectives, series of distinct goods or services, measures of progress, the royalty constraint, and the practical expedient of paragraph 55-18. Any approach that includes estimates is subject to re-evaluation as conditions impacting revenue may change. The following provides a comparison of the revenue recognition patterns for each View from the above case facts of Fable Productions:
|Minimum Guarantee: $300K||Y1||Y2||Y3||Y4||Y5||Total|
|Cumulative Royalties Received||$60K||$145K||$260K||$340K||$475K|
|View A||Annual Revenue||$60K||$85K||$115K||$80K||$135K||$475K|
|View B||Annual Revenue||$95K||$95K||$95K||$55K||$135K||$475K|
|View C||Annual Revenue||$60K||$60K||$60K||$100K||$195K||$475K|
Licensing contracts with sales- and usage-based royalties often include minimum guarantees to reduce risks taken on by the licensor. These minimum guarantees complicate revenue recognition. The foregoing case study examined the revenue recognition for a license of symbolic IP with a minimum guarantee. Alternative approaches deemed acceptable by the TRG were also summarized and compared.
- ASC 606
- FASB TRG Memo 58: “Sales-Based or Usage-Based Royalty with Minimum Guarantee.” 7 November 2016.