Licenses of Intellectual Property

The New Revenue Recognition Standard and Accounting for Licenses

Wiley author, Joanne Flood, looks at how the new revenue standard affects reporting of licensing revenue. Copyright Wiley, 2016. To be published in February 2017 in the book: Wiley Revenue Recognition plus Website: Understanding and Implementing the New Standard (Wiley Regulatory Reporting).

[su_pullquote align=”right”]Resources:

Intangible Asset Valuation and Fair Value Accounting

Where, When, and How to Value Intellectual Property

What You Can’t See Has Value—The Valuation of Intangible Assets

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In May 20, 2014, the FASB issued its new revenue recognition standard.  The changes are significant and the scope of the standard is wide.  It affects all public companies, nonpublic companies, and nonprofit organizations.  The following is an overview of the effects on intellectual property (IP) licenses.

Licenses of Intellectual Property

A license arrangement establishes a customer’s right to an entity’s IP and the entity’s obligations to provide these rights.  With the prevalence of technology in every business, accounting for IP licenses has become more critical than ever.  In addition to the software industry, IP licenses are common in industries such as:

• Entertainment and media
• Pharmaceuticals
• Retail and consumer
• Franchise

Most companies are now dealing with the transition to the new standard.  The new standard may affect a company’s timing of revenue recognition.  These accounting changes may also affect a company’s valuation.  For example, technology companies commonly use valuations for share-based compensation, valuing assets in a business combination, earnouts, and impairment testing.  By changing the timing of revenue recognition, the accounting changes may, at least in the short term, affect the metrics used in valuations.  Valuation specialists need to be aware of how the standard works and the possible effects of its changes.  Small business and individual clients may be affected by the standard’s impact on share-based compensation and income from earnouts.

Recognition

Recognition of licensing revenue depends on the nature of the license.

• Revenue from a license of IP that is a right to access should be recognized over time.
• Revenue from a license of IP that is a right to use should be recognized at a point in time.

Once the entity determines that the revenue from the license should be recognized over time or at a point in time, the entity should apply the guidance in Step 5 of the new revenue recognition model to determine the point in time or to select the appropriate method to measure the revenue over time.  (See Quick Read article, “FASB Issues New Standard for Lease Accounting: Expanding the Lessors Qualitative and Quantitative Disclosures” March 31, 2016, for an overview of the revenue recognition model.)  In any case, revenue cannot be recognized from an IP license before:

• The entity has made available a copy of the IP to the customer; and
• The license period has begun.

(ASC 610-10-55-58C; IFRS 15.61)

Accounting for Licenses under the New Standard

Assessing Whether a License is Distinct

In determining whether a license is a right to access or a right to use, entities first should assess if a license represents a distinct performance obligation; including whether the customer can benefit from the license on its own or together with other readily available resources, and whether the license is separately identifiable from other goods or services in the contract.  The guidance in this article only relates to distinct licenses.

Identifying the Nature of the Entity’s Promise

To identify when the customer takes control of an asset and, thus, when it recognizes revenue, it is necessary to identify the nature of the entity’s performance obligation.  When accounting for a performance obligation that includes a license and other goods or services, the entity should consider the nature of its promise in granting a license.  The standard classifies all distinct licenses of intellectual property into two categories:

1. A right to access the entity’s intellectual property throughout the license period (or its remaining economic life, if shorter); and
2. A right to use the entity’s intellectual property as it exists at the point in time at which the license is granted (Emphasis added.).

(ASC 606-10-55-58)

Exhibit I: Comparison of Right to Access and Right to Use

	Right to Access	Right to Use
Description	Customer simultaneously receives and consumes the benefit of the IP license as the entity performs The entity undertakes activities that significantly affect the IP (required indirectly by the contract or the customer’s reasonable expectation based on business practices, published policies, or specific statements) Those activities affect, positively or negatively, the customer Those activities do not result in transfer of goods or services	The license does not meet the criteria for a right to access license
Examples	Brand, team or trade names, logos, franchise rights	Software, biological compounds, drug formulas, and completed media content (films, TV shows, music)
Recognition	Recognize over time, with an appropriate method, because the customer simultaneously receives and consumes the benefit of the IP	Recognize at a point in time because the customer has control: it can direct the use of and benefit from the license at the point in time at which the license transfers
(ASC 606-10-55-58A and 55-58B)

The entity should assess whether the IP is expected to change during the term of the license.  A customer does not meet the criteria for control if the IP is expected to change.  If the entity is expected to be involved in the IP and undertake activities that significantly affect the licensed IP, this may be an indication the IP is expected to change.

To determine if a customer could expect the entity to undertake activities that significantly affect the IP, the entity should consider:

• Customary business practices, published policies, or specific statements; and
• Shared economic interest, such as a sales-based royalty.

FASB’s Clarified Guidance

In response to concerns about how to determine whether a license is a right to use or a right to access IP, in ASU 2016-10, the FASB provides clarified guidance about the nature of the license.  The FASB’s approach looks to the nature of the IP and focuses on whether activities undertaken by the entity significantly affect the IP.  The license is either functional or symbolic and that category determines whether the license is a right to access or a right to use.  For both types of IP, the entity cannot recognize revenue before the beginning of the period in which the customer can use and benefit from the license.

Exhibit II: Categories of Distinct Licenses of Intellectual Property—FASB’s Alternative Approach

	Symbolic IP	Functional IP
Description	This IP does not have significant standalone functionality.  It represents something else.  The lack of stand-alone functionality indicates that substantially all of the utility is derived from the entity’s past or ongoing activities of the entity. It is assumed that the entity will continue to support and maintain the IP	Customer derives a substantial portion of its benefit from standalone functionality The licensor’s ongoing activities do not significantly affect the utility of the IP
Examples	Brand, team or trade names, logos, franchise rights	Software, biological compounds, drug formulas, and completed media content (films, TV shows, music)
Recognition	Over the license period using a measure of progress that reflects the licensor’s pattern of performance	At a point in time* when control of the IP transfers to the customer, that is, when the IP is available for the customer’s use and benefit (*Unless the functionality of IP is expected to substantively change the form or functionality as a result of activities performed by the entity that are not separate performance obligations and the customer would be required or compelled to use the latest version of the IP.  This would indicate that the customer has a right to access the IP.  In such cases, the activities significantly affect the customer’s ability to benefit from the IP and revenue would be recognized over time.)

Symbolic License

With a symbolic license, the IP may change over the course of time.  This can occur because of the entity’s continuing involvement with activities that affect its IP.  Even if the right is unchanged, the benefit or value to the customer may be affected by the licensor’s activities during the license period.  With symbolic IP, the entity fulfills its obligation over time, as the entity:

• Grants the customer rights to use and benefit from the entity’s intellectual property by making it available for the customer’s use; and
• Supports or maintains the intellectual property.

(ASC 606-10-55-60)

The customer has an expectation that the entity will undertake positive activities to maintain the value of the IP and avoid actions that would reduce the value of the IP.

Functional License

A functional IP license generally grants the customer the right to use the IP at a point of time.  However, if both of the following criteria are met, the license grants a right to access the IP:

• The functionality of the intellectual property to which the customer has rights is expected to substantively change during the license period because of activities of the entity that do not transfer a good or service to the customer; and
• The customer is contract or practically required to use the updated IP resulting from criterion “a.”

(ASC 606-10-55-62)

The IP’s utility may be significantly affected when:

• The expected activities are expected to change the form or the functionality of the IP; or
• The value for the customer of the IP is substantially derived from or dependent on the expected activities of the entity.

Examples of these might be when the ability to perform a function or the value of a logo changes.

Effective Date

The effective date depends on whether entities are public or nonpublic entities.  The effective dates are summarized below.

Exhibit III: Summary of Deferred Effective Dates

	U.S. GAAP Public	U.S. GAAP Nonpublic
Effective Date	Annual periods (and interim periods within) beginning after December 15, 2017	Annual periods beginning after December 15, 2018
Early Adoption	Yes, but no earlier than the original effective date	Yes, but no earlier than the original effective date for U.S. Public entities

Joanne Flood, MBA, CPA, (Rockville Centre, NY) has accounting experience within both a Big 4 international firm and a small firm. She has worked as a senior manager in the AICPA’s Professional Development group. Ms. Flood received her MBA in Accounting Summa Cum Laude from Adelphi University. While in public accounting, she worked on major clients in retail, manufacturing, and finance, and on small business clients in construction, manufacturing, and professional services.
Ms. Flood can be reached at (516) 536-4374 or by e-mail to jmflood3@optonline.net.