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Licenses of intellectual property frequently include fees that are based on the customer’s subsequent usage of the IP or sale of products that contain the IP. The revenue standard includes an exception for the recognition of sales- or usage-based royalties promised in exchange for a license of IP.

Excerpt from ASC 606-10-55-65

Notwithstanding the guidance in paragraphs 606-10-32-11 through 32-14, an entity should recognize revenue for a sales-based or usage-based royalty promised in exchange for a license of intellectual property only when (or as) the later of the following events occurs:

  1. The subsequent sale or usage occurs.
  2. The performance obligation to which some or all of the sales-based or usage-based royalty has been allocated has been satisfied (or partially satisfied).

This guidance is an exception to the general principles for accounting for variable consideration (refer to RR 4 for further discussion of variable consideration). The exception only applies to licenses of IP and should not be applied to other fact patterns by analogy. Further, reporting entities that sell, rather than license, IP cannot apply the sales- or usage-based royalty exception. Sales- or usage-based royalties received in arrangements other than licenses of IP should be estimated as variable consideration and included in the transaction price, subject to the constraint (refer to RR 4.3.2), and recognized when the related performance obligations are satisfied.
The above “later of” guidance for royalties is intended to prevent the recognition of revenue prior to a reporting entity satisfying its performance obligation. Royalties should be recognized as the underlying sales or usages occur, as long as this approach does not result in the acceleration of revenue ahead of the reporting entity’s performance. As noted in RR 9.5, the revenue standard does not prescribe a method for measuring a reporting entity’s performance for a right to access IP (that is, a license for which revenue is recognized over time). Management should therefore apply judgment to determine whether recognizing royalties due each period results in accelerating revenue recognition ahead of performance for a right to access IP. It may be appropriate, in some instances, to conclude that royalties due each period correlate directly with the value to the customer of the reporting entity’s performance.
Question RR 9-2 addresses the accounting for royalties promised in exchange for an in-substance sale of IP.
Question RR 9-2
How should reporting entities account for sales- or usage-based royalties promised in exchange for a license of IP that in substance is the sale of IP?
PwC response
The exception for sales- or usage-based royalties applies to licenses of IP and not to sales of IP. The FASB noted in its basis for conclusions that a reporting entity should not distinguish between licenses and in-substance sales in deciding whether the royalty exception applies.
Question RR 9-3
Is a reporting entity permitted to recognize sales- or usage-based royalties prior to the period the sales or usages occur if management believes it has historical experience that is highly predictive of the amount of royalties that will be received?
PwC response
No, application of the exception is not optional. Sales- or usage-based royalties in the scope of the exception cannot be recognized prior to the period the uncertainty is resolved (that is, when the customer’s subsequent sales or usages occur).
Question RR 9-4
Should sales- or usage-based royalties promised in exchange for a license of IP be recognized in the period the sales or usages occur or the period such sales or usages are reported by the customer (assuming the related performance obligation has been satisfied)?
PwC response
The exception states that royalties should be recognized in the period the sales or usages occur (assuming the related performance obligation has been satisfied). It may therefore be necessary for management to estimate sales or usages that have occurred, but have not yet been reported by the customer.
Question RR 9-5
A reporting entity (an agent) distributes licenses of IP on behalf of the owner of the IP (the licensor). The reporting entity is a distribution agent and accordingly, performs an agency service for the licensor. The agent’s compensation is in the form of a specified percentage of the royalties the licensor receives from its customers. Those royalties are calculated based on the licensor’s customers’ sales (that is, a sales-based royalty). Can the agent also apply the exception for sales- or usage-based royalties?
PwC response
We believe it would be acceptable for the agent to apply the exception for sales- or usage-based royalties. As discussed in BC415, applying the exception in this case is consistent with the reasons the boards concluded that reporting entities should not estimate royalties from licenses of IP and provided the royalty exception. Additionally, in this fact pattern, the service provided by the agent is directly related to the license of IP. Application of the sales- or usage-based royalty exception may not be appropriate in circumstances when a reporting entity receives a share of a royalty stream as compensation, but its performance is clearly unrelated to the license of IP.
We believe it would also be acceptable for the agent to conclude its fee is not subject to the exception for sales- or usage-based royalties. This conclusion would be based on the fact that the agent’s performance obligation is a service, not the license of IP. A reporting entity concluding its fee is not subject to the exception would apply the general guidance on variable consideration (including the variable consideration constraint) and recognize revenue as the service is performed, as opposed to recognizing revenue in the period the licensor’s customers’ sales occur. The reporting entity’s conclusion should be applied consistently to similar arrangements.
Question RR 9-6
Does the exception for sales- or usage-based royalties impact the determination of the transaction price (step 2) or the recognition of revenue (step 5)?
PwC response
The sales- or usage-based royalty exception is a constraint on the recognition of revenue in step 5 of the revenue recognition model. That is, sales- or usage-based royalties are included in the transaction price as part of step 2, similar to other variable consideration, but recognition of the royalty in step 5 is precluded prior to the period the sales or usages occur. This concept is illustrated in Example 35 of the revenue standard (ASC 606-10-55-270 through ASC 606-10-55-279). Often, it is not necessary to estimate royalties at contract inception because the exception precludes recognition prior to the period the sales or usages occur. However, in some instances, it may be necessary to estimate royalties as part of determining and allocating the transaction price. For example, it may be necessary to estimate royalties to apply the guidance on allocating variable consideration (refer to RR 5.5.1) or when accounting for arrangements that include minimum royalties (refer to RR 9.8.3).
Question RR 9-7
A reporting entity licenses functional IP to a customer in exchange for a sales-based royalty and concludes that its performance obligation is satisfied when the license period begins. The calculation of the sales-based royalty is based on a royalty rate that decreases over the term of the contract. Should the reporting entity calculate an average royalty rate to determine the amount of revenue to recognize when the customer’s subsequent sales occur?
PwC response
No. Under the sales- or usage-based royalty exception, the amount included in the transaction price is the contractually-specified royalty amount. Since the related performance obligation has already been satisfied in this scenario, revenue is recognized once the consideration is no longer contingent on future sales. Therefore, revenue should be recognized once the sale occurs regardless of the rate or method used to calculate the royalty.

9.8.1 Royalty related to a license and other goods or services

Some arrangements include sales- or usage-based royalties that relate to both a license of intellectual property and other goods or services. The revenue standard includes the following guidance for applying the sales- or usage-based royalty exception in these fact patterns.

Excerpt from ASC 606-10-55-65A

The guidance for a sales-based or usage-based royalty… applies when the royalty relates only to a license of intellectual property or when a license of intellectual property is the predominant item to which the royalty relates (for example, when… the customer would ascribe significantly more value to the license than to the other goods or services to which the royalty relates).

The revenue standard does not further define “predominant” or “significantly more value” and, therefore, judgment may be required to make this assessment. Management will either apply the exception to the royalty stream in its entirety (if the license to IP is predominant) or apply the general variable consideration guidance (if the license to IP is not predominant). Management should not “split” the royalty and apply the exception to only a portion of the royalty stream.
Example RR 9-9 and Example RR 9-10 illustrate the assessment of whether a license of IP is predominant when the related fee is in the form of a sales- or usage-based royalty. This concept is also illustrated in Example 60 of the revenue standard (ASC 606-10-55-393 through ASC 606-10-55-394).
EXAMPLE RR 9-9
Sales- or usage-based royalties – license of IP is not predominant
Biotech and Pharma enter into a multi-year agreement under which Biotech licenses its IP to Pharma and agrees to manufacture the commercial supply of the product as it is needed. In this agreement, the license and the promise to manufacture are each distinct, and the value of each is determined to be about the same. The only compensation for Biotech in this arrangement is a percentage of Pharma’s commercial sales of the product.
Does the sales- or usage-based royalty exception apply to this arrangement?
Analysis
No, the exception does not apply because the license of IP is not predominant in this arrangement. The customer would not ascribe significantly more value to the license than to the promise to manufacture product. Biotech would apply the general variable consideration guidance to estimate the transaction price, and allocate the transaction price between the license and manufacturing. The portion attributed to the license will be recognized by Biotech when the IP has been transferred and Pharma is able to use and benefit from the license. The remaining transaction price would be allocated to the manufacturing and recognized when (or as) control of the product is transferred to Pharma.
EXAMPLE RR 9-10
Sales- or usage-based royalties – license of IP is predominant
Pharma licenses to Customer its patent rights to an approved drug compound for eight years. The drug is a mature product. Pharma also promises to provide training and transition services related to the manufacturing of the drug for a period not to exceed three months. The manufacturing process is not unique or specialized, and the services are intended to help Customer maximize the efficiency of its manufacturing process. Pharma concludes that both the license of IP and the services are distinct. The only compensation for Pharma in this arrangement is a percentage of Customer’s commercial sales of the product.
Does the sales- or usage-based royalty exception apply to this arrangement?
Analysis
Yes, the exception applies because the license of IP is predominant in this arrangement. The customer would ascribe significantly more value to the license of IP than to the training and transition services included in the arrangement. As such, Pharma would allocate the transaction price to the license and the services and recognize revenue as the subsequent sales occur (assuming Pharma has satisfied its performance obligations).

9.8.2 In substance sales- or usage-based royalties

Management will need to consider the nature of any variable consideration promised in exchange for a license of intellectual property to determine if, in substance, the variable consideration is a sales- or usage-based royalty. Examples include arrangements with milestone payments based upon achieving certain sales or usage targets and arrangements with an upfront payment that is subject to "claw back" if the licensee does not meet certain sales or usage targets.
Example RR 9-11 and Example RR 9-12 illustrate the assessment of whether the sales- or usage-based royalty exception applies.
EXAMPLE RR 9-11
Sales- or usage-based royalties – milestone payments
TechCo licenses IP to Manufacturer that Manufacturer will utilize in products it sells to its customers over the license period. TechCo will receive a fixed payment of $10 million in exchange for the license and milestone payments as follows:
  • An additional $5 million payment if Manufacturer’s cumulative sales exceed $100 million over the license period
  • An additional $10 million payment if Manufacturer’s cumulative sales exceed $200 million over the license period
TechCo concludes that the license is a right to use IP. There are no other promises included in the contract.
Does the sales- or usage-based royalty exception apply to the milestone payments?
Analysis
Yes, the exception applies to the milestone payments because the payments are promised in exchange for a license of IP and are contingent on Manufacturer’s subsequent sales. TechCo would recognize the $10 million fixed fee when control of the license transfers to Manufacturer. TechCo would recognize the milestone payments in the period(s) that sales exceed the cumulative targets.
EXAMPLE RR 9-12
Sales- or usage-based royalties – claw back of upfront payment
TechCo licenses IP to Manufacturer that Manufacturer will utilize in products it sells to its customers over the license period. TechCo will receive an upfront payment of $20 million and the contract provides for clawback of $5 million in the event Manufacturer’s cumulative sales do not exceed $100 million over the license period. TechCo concludes it is probable that Manufacturer’s cumulative sales will exceed the target.
Does the sales- or usage-based royalty exception apply to this arrangement?
Analysis
Yes, the arrangement consists of a $15 million fixed fee and a $5 million variable fee that is in the scope of the sales- or usage-based royalty exception because it is promised in exchange for a license of IP and is contingent on Manufacturer’s subsequent sales. TechCo would recognize the $15 million fixed fee when control of the license transfers to Manufacturer. TechCo would recognize the $5 million contingent fee in the period sales exceed the cumulative target. The accounting would not be impacted by the likelihood that Manufacturer will reach the cumulative target because the payment is in the scope of the sales- or usage-based royalty exception, which requires recognition in the period the uncertainty is resolved (that is, when the sales occur).

9.8.3 Minimum royalties or other fixed fee components

The sales- or usage-based royalty exception does not apply to fees that are fixed and are not contingent upon future sales or usage. Some arrangements include both a fixed fee and a fee that is a sales- or usage-based royalty. Any fixed, noncontingent fees, including any minimum royalty payments or minimum guarantees, are not subject to the sales- or usage-based royalty exception.
A fixed fee in exchange for a license that is a right to use intellectual property is recognized at the point in time control of the license transfers. Thus, if a contract includes a sales-based royalty with a minimum royalty guarantee that is binding and not contingent on the occurrence or non-occurrence of a future event, the minimum (fixed fee) would be recognized as revenue when control of the license transfers. Royalties in excess of the minimum would be recognized in the period the sales occur.
A fixed fee in exchange for a license that is a right to access IP is recognized over time. We believe there could be multiple acceptable approaches for recognizing revenue when a license that is a right to access IP includes a sales- or usage-based royalty and a minimum royalty guarantee. Examples of acceptable approaches include:
  • Recognize revenue as the royalties occur if the licensor expects the total royalties to exceed the minimum guarantee and the royalties due each period correspond directly with the value to the customer of the reporting entity's performance (that is, recognizing royalties as they occur is an appropriate measure of progress using the right to invoice practical expedient discussed in RR 6.4.1.1).
  • Estimate the total transaction price (including fixed and variable consideration) that will be earned over the term of the license. Recognize revenue using an appropriate measure of progress; however, the sales- or usage-based royalty exception must continue to be applied to the cumulative revenue recognized.
  • Recognize the minimum guarantee (fixed consideration) using an appropriate measure of progress, and recognize royalties only when cumulative royalties exceed the minimum guarantee.
The selection of an approach could require judgment and should consider the nature and terms of the specific arrangement. Refer to US Revenue TRG Memo No. 58 and the related meeting minutes in Revenue TRG Memo No. 60  for further discussion of this topic.
Example RR 9-13 illustrates the accounting for an arrangement with a guaranteed minimum royalty.
EXAMPLE RR 9-13
Sales- or usage-based royalties – minimum guarantee
TechCo licenses IP to Manufacturer that Manufacturer will utilize in products it sells to its customers over a five-year license period. TechCo will receive a royalty based on Manufacturer's sales during the license period. The contract states that the minimum royalty payment in each year is $1 million. TechCo expects actual royalties to significantly exceed the $1 million minimum each year.
TechCo concludes that the license is a right to use IP. There are no other promises included in the contract and control of the license transfers on January 1, 20X1. There is not a significant financing component in the arrangement.
When should TechCo recognize revenue from the arrangement?
Analysis
The minimum royalty of $5 million ($1 million x five years) is a fixed fee. Since the license is a right to use IP, subject to point-in-time revenue recognition, TechCo would recognize the $5 million fixed fee on January 1, 20X1 when control of the license transfers to Manufacturer. TechCo would apply the sales- or usage-based royalty exception guidance for the royalty and recognize the royalties earned in excess of $1 million each year in the period sales occur. The fact that actual royalties are expected to significantly exceed the minimum does not impact the accounting conclusion.

9.8.4 Distinguishing usage-based royalties from additional rights

Many license arrangements include a variable fee linked to usage of the IP. It may not be clear, particularly for software licenses, whether this fee is a usage-based royalty or a fee received in exchange for the purchase of additional rights by the customer. If a licensor is entitled to additional consideration based on the usage of intellectual property to which the customer already has rights, without providing any additional or incremental rights, the fee is generally a usage-based royalty. In contrast, if a licensor provides additional or incremental rights that the customer did not previously control for an incremental fee, the customer is likely exercising an option to acquire additional rights.
Judgment might be required to distinguish between a usage-based royalty (a form of variable consideration) and an option to acquire additional goods or services. A usage-based royalty is recognized when the usage occurs or the performance obligation is satisfied, whichever is later. The usage-based royalty may need to be disclosed in the period recognized pursuant to the requirements to disclose revenue recognized in the reporting period from performance obligations satisfied in previous periods (refer to FSP 33.4.3.3). Fees received when an option to acquire additional rights is exercised are recognized when the additional rights are transferred; however, at contract inception, management would need to assess whether the option provides a material right (refer to RR 7). If so, a portion of the transaction price would be allocated to the option and deferred until the option is exercised or expires.
Example RR 9-14 and Example RR 9-15 illustrate the assessment of whether variable fees represent a usage-based royalty or an option to acquire additional rights.
EXAMPLE RR 9-14
Variable fees – usage-based royalty
SoftwareCo licenses software to a customer that will be used by the customer to process transactions. The license permits the customer to grant an unlimited number of users access to the software for no additional fee. The contract consideration includes a fixed upfront fee and a variable fee for each transaction processed using the software.
How should SoftwareCo account for the variable fee?
Analysis
SoftwareCo should account for the variable fee as a usage-based royalty. The incremental fees SoftwareCo receives are based on the usage of the software rights previously transferred to the customer. There are no additional rights transferred to the customer; therefore, SoftwareCo should recognize the usage-based royalty in the period the usage occurs.
EXAMPLE RR 9-15
Variable fees – option to acquire additional rights
On January 1, 20X1, SoftwareCo licenses to a customer the right to use its software for five years for a fixed price of $1 million for 1,000 users (or "seats"). $1,000 per user is the current standalone selling price for the software. The contract also provides that the customer can add additional users during the term of the contract at a price of $800 per user. Management has concluded that each "seat" is a separate performance obligation and in substance the customer obtains an additional right when a new user is added.
On January 1, 20X2, Customer adds 20 users and pays SoftwareCo an additional $16,000.
How should SoftwareCo account for the variable fee?
Analysis
The variable fee in this arrangement is an option to purchase additional rights to use the software because the rights for the additional users are incremental to the rights transferred to the customer on January 1, 20X1. SoftwareCo will need to assess whether the option provides a material right and if so, allocate a portion of the $1 million transaction price to the option. The amount allocated to the option would be deferred until the option is exercised or expires. In this fact pattern, the discounted pricing of $800 per user compared to the current pricing of $1,000 per user may indicate that the option provides a material right if the customer would not have received the discount without entering into the current contract.
SoftwareCo would recognize the $16,000 fee for the additional rights when it transfers control of the additional licenses. SoftwareCo would also recognize amounts allocated to the related material right, if any, at the time the right is exercised.

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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