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 Variable Consideration and the Constraint. 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). A flowchart is provided at the end of the article to visually summarize the entire process for recognizing sales- and usage-based royalties.
The Financial Accounting Standards Board (FASB or “the Board”) determined that the differences between sales- and usage-based royalties and variable consideration are significant enough to warrant specific attention. The Board members observed that the largest challenge in accounting for sales- and usage-based royalties is that royalty cash flows depend solely on the performance of the licensee and are generally independent of the licensor’s performance, which makes sales- and usage-based royalty cash flows uncertain and unpredictable.
Consequently, the Board was concerned about the potential impact that these royalties could have on the relevance and quality of financial statement information. To address these issues, the new standard provides an exception to the guidance for estimating variable consideration for sales- and usage-based royalties in ASC 606-10-55-65. Because the exception provides guidance specifically tailored to sales- and usage-based royalties, the exception should not be applied to any other fact pattern – even by analogy [Accounting Standards Update (ASU) 2014-09 Basis for Conclusion (BC)415 through BC421].
Criteria for Exception
In order for a royalty to qualify for the exception, it must meet two 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 sales- or usage-based 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.
Example – Sales-based Royalty
Harper, a singer has licensed his music to an online music retailer, Pentatonic. Pentatonic pays Harper $0.25 for every song of his sold through their website. In the first month, Pentatonic only sold five songs by Harper and wrote a (rather lousy) check to Harper for $1.25 – enough for a few sticks of his favorite wintergreen gum.
However, the next month, with the advent of Harper’s first hit song, “Wintergreen Love,” Pentatonic sells 10 million songs. Pentatonic cuts a check for the (rather tidy) sum of $2.5 million – which Harper often quips is “enough to buy the whole factory where the wintergreen gum is made.” Because Harper is paid royalties based on Pentatonic’s sales of his songs (IP), the royalty is sales-based.
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.
Example – Usage-based Royalty
Jamison & Co. engineers and manufactures synthetic polycrystalline diamond bits for mining and petroleum application. Jamison operates hundreds of proprietary hydraulic presses that are designed to significantly reduce production time. In the press, carbon crystallizes into microscopic diamonds under immense pressure and heat, which are then cemented together in tungsten-carbide. The resulting product is ground to specifications and brazed onto drill bits.
Jamison has decided to license its proprietary diamond press technology to a German company, Osterreich Diamant. Osterreich has agreed to pay $500,000 per year in royalties for each press utilizing Jamison’s proprietary technology. Because the royalty payments are based on how many presses use Jamison’s IP every year to produce industrial diamonds, the royalty is usage-based.
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. While 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. For more information on related tentative guidance read the Additional Considerations section.
Royalties Applicable to Multiple Promised Goods or Services. In order for the exception to apply, a royalty must also relate either solely or predominantly to a license of IP. For any other type of license agreement, the exception does not apply. However, 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 with maintenance, consulting, or training services. Prior to ASC 606, no specific guidance on how to account for a royalty in these situations was available. However, 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.
Example – Royalty Partially Related to License of IP
Willy Corporation (Willy) manufactures aftermarket automotive performance parts and specializes in drive-train and valve-train components. At its plant in Dearborn, Michigan, Willy manufactures stroker kits, which are specially designed crankshaft assemblies that increase performance. Recently, management has determined that it is more profitable to license the technology than to manufacture it. Consequently, Willy has agreed to license the IP associated with the manufacture of stroker kits along with the machining equipment and tooling from its Detroit plant to Tomakasagi. In exchange, Tomakasagi has agreed to pay 10 percent of gross revenues resulting from stroker kit sales.
The agreement was structured so that, instead of a flat fee for the equipment, the royalty is consideration for both the equipment and IP. However, Tomakasagi is most interested in the IP. Procuring the equipment from Willy, which is fairly standard industrial machining equipment, is merely for convenience and is not absolutely necessary to implement the IP. Tomakasagi can easily obtain this equipment elsewhere. After analyzing the contract, Willy has determined that while the equipment is related to the IP, it is not related highly enough to warrant combination of the IP and equipment into a single performance obligation. Also, due to Tomakasagi’s relative interest in the IP, and the general nature of the industrial equipment, Willy has determined that the license of IP is the predominant item in the arrangement, and that the entire royalty stream is covered by the exception as found in ASC 606-10-55-65.
Other Considerations. 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 (KPMG Issues in Depth – Revenue p. 230).
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.
Example – Assigning and Allocating Royalties
Assume the same facts as the prior example. According to the allocation principle for variable consideration, Willy should allocate part of the royalty to each performance obligation, because the royalty is intended to pay for both the machinery and the IP. The estimated market value of the machinery at the time Tomakasagi acquired it was $10 million, while the estimated value of the IP is $15 million.
Consequently, Willy has determined that 40 percent of the royalty should be allocated to the machinery and the remaining 60 percent should be allocated to the IP because these percentages best reflect the consideration that Willy expects to receive for each performance obligation. Note that no amount in connection with the royalty can be included in the transaction price until sales or usage occurs. At the end of the first month, after the license was in effect and the machinery was delivered, Tomakasagi generated $5 million in revenue relating to the stroker kits. Per the agreement, Willy received $500,000 because the contingent sales occurred. Consequently, $200,000 was added to the transaction price allocated to the machinery and $300,000 was added to the transaction price allocated to the IP.
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 upon occurrence of the later of the following events:
- 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 Board has removed the uncertainty in estimating these royalties. Ultimately, these criteria were designed to protect the relevance and quality of financial statements information (ASU 2014-09 BC415).
Example – Recognizing Revenue
Assume the same facts as the prior two examples. Because Willy has delivered the machinery, that performance obligation has been wholly satisfied. Thus, subsequent usage or sales is the later of the two requirements for revenue recognition. Therefore, Willy may recognize $200,000 (i.e., $500,000 multiplied by 40 percent) in royalties relating to the promise to deliver the machinery. In addition, the license of IP has already been transferred to, and is in use by, Tomakasagi. As such, the promise to transfer the license of IP is satisfied and revenue recognition is limited only by the subsequent sales and usage of the IP. Willy may recognize $300,000 in revenue when the subsequent sales occur. In total, Willy will recognize $500,000 on the sales Tomakasagi made this month related to Willy’s IP and machinery.
Comparison to ASC 605
Under ASC 605, sales- and usage-based royalties are recognized when they become fixed and determinable. Royalties are considered fixed and determinable as the sale or usage occurs, regardless of whether or not the license is for IP. This guidance can be found in Staff Accounting Bullet (SAB) 13 or in ASC 605-28 (KPMG Issues-in-Depth – Revenue from Contracts with Customers Section 10.11).
Under the new 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.
Accounting Standards Update (ASU) 2016-10, issued by the FASB in April 2016 addresses the subject of this article. ASU 2016-10 codifies a required criterion for applying the sales- and usage-based royalty exception described in this article, replacing a tentative FASB Board decision reached on the matter. The changes made to ASC 606 as a result of this update are reflected in the article above.
- ASC 605-28; ASC 606-10-32-6, 32-11 through 32-14, 32-28; ASC 606-10-55-65
- ASU 2014-09, Revenue with Contracts with Customers. “Basis for Conclusions.” BC 415-BC 421.
- ASU 2016-10, “Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing.”
- FASB/IASB, Tentative Board Decisions: “Revenue Recognition Research Projects.” February 11, 2015.
- “KPMG, Handbook: “Revenue Recognition.” November 2018. Section 10.11 “Sales- or usage-based royalty exception.”
- SEC, Staff Accounting Bulletin 13: “Revenue Recognition.“