LICENSES FOR INTELLECTUAL PROPERTY

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.
To properly account for licenses of IP, we must complete a sequence of analyses. These analyses
include:
(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. Entities must determine if relevant transactions involve
the sale or license of IP. Licenses transfer rights to IP, while sales transfer ownership of the IP.
Sales of IP are accounted for using the general revenue recognition model (five-step process)
instead of the licensing guidance here.

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 separate and distinct
performance obligation, that is, if the license is:
(1) capable of being distinct and
(2) 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.
Example: machinery with integral embedded software.
• When the license is required for a customer to benefit from a related service.
Example: 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. Conversely, if the license is distinct, then it is a separate
performance obligation. In a separate performance obligation, we must determine the nature of
the license to assess the timing of revenue recognition.
The Nature of the License. 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. There are two
types of licenses. The licenses are classified to assist us 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, 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. Utility means its
ability to provide benefit or value. 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 when the license is delivered. However, certain functional IP may still
provide rights to access IP if the following two criteria are met:
(a) 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.
(b) The customer is contractually or practically required to use the updated intellectual
property resulting from the activities in criterion (a).
The purpose of the above criteria is to maintain consistency with the conceptual underpinnings of
the licensing guidance. 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. It is
because the updates to IP often transfer additional promised goods or services, the criteria apply
only in some situations.

Example 1
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: 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. This is 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, revenue will be
recognized upon license delivery.

Example 2
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: 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, this license provides a right to access the software and
revenue will be recognized over time.

Symbolic IP. Symbolic IP 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, trade names, etc.

Example 3
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:

Royalties and Licensing Arrangements

In some instances, entities receive sales-based or usage-based royalties in consideration for their
licensing of intellectual property. A royalty predominately related to a license is subject to a
constraint (hereafter referred to as the constraint on royalties) that is different than the general
constraint on variable consideration. The constraint on royalties requires that regardless of the
analysis of whether a license is a right to use or a right to access intellectual property, any
variable consideration in the form of a royalty should not be recognized until the uncertainty
over the amount of the royalty is resolved.

Entities only apply the constraint on royalties when the royalty is predominately related to the
license of intellectual property. Furthermore, if the royalty is predominately related to a license,
entities must account for the royalty by applying the constraint on royalties to the whole royalty;
that is, organizations cannot subdivide royalties that are predominately based on licensed
intellectual property into portions subject to the constraint on royalties and portions subject to the
general constraint on variable consideration.

To illustrate this point, further consider Scenario 3 in the example described above. Because the
royalty was considered to predominately relate to the license of a patent, it cannot be subdivided
into components that are subject to the royalty guidance and a portion subject to the standard
variable consideration guidance. Therefore, the amount of royalty allocated to the engineering
services cannot be recognized until the later of transfer of the engineering services or resolution
of the uncertainty over the amount of royalty to be received. When the customer sells products
utilizing the patent, thus entitling the entity to payments under the royalty, revenue would be
recognized and allocated between the license and the engineering services.

Even though a royalty is subject to the constraint on royalties, an entity is not permitted to skip
the analysis of when the performance obligations are transferred to the customer. For instance,
consider if in the above scenario the license was transferred on Day 1, but the engineering
services were not performed until Day 30. If the customer sold units entitling the entity to $5,000
of royalty payments on Day 10, the amount of the royalty payments that were allocated to the
engineering services would be deferred until Day 30.
However, if the royalty is not predominately based on the license of intellectual property, then
the royalty should be accounted for in the same manner as other variable consideration, which
requires that it be estimated subject to the constraint on variable consideration when determining
the transaction price (Step 3).
Contractual 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
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
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).