Under the new revenue standard, licenses will be considered either functional or symbolic, and this will determine the pattern of revenue recognition. Watch PwC’s Roxanne Fattahi discuss the new revenue standard where she discusses: what to do when a license is bundled with other promised goods and services in the contract, how to determine when the license is distinct, how to determine whether the intellectual property underlying the license is functional or symbolic.
Hi, I’m Roxanne Fattahi.
The new revenue standard includes specific guidance for accounting for licenses of intellectual property. While broadly applicable, this guidance is expected to have a significant impact on companies in the media and entertainment, software, technology and pharmaceutical industries. To provide a bit of background, the guidance in this area was the subject of much debate even before the original standard was issued. Then, in April 2016, the FASB issued an amendment to the original standard in an effort to clarify the guidance in this area.
First, the FASB clarified when to apply the licensing guidance when the license is bundled with other promised goods and services in the contract. For example, a license granted to a customer which enables the customer to access online content would not be distinct from the online service. To the extent the license is not distinct from the other promised goods or services, the amendment clarified that entities will need to determine whether the combined performance obligation is satisfied over time or at a point in time. On the other hand, when the license is distinct, an entity needs to determine whether the intellectual property underlying the license is functional or symbolic. This is an important distinction because the nature of the intellectual property will impact the timing of revenue recognition related to the license.
Functional IP has significant stand-alone functionality and derives a substantial portion of its utility from this characteristic. Revenue from a license of functional IP is recognized at the point in time that control of the IP is transferred to the customer. Common examples of functional IP include software, drug formulas, and completed media content. Symbolic IP is anything that is not functional IP. Revenue from a license of symbolic IP is recognized over time using an appropriate measure of progress. Some common examples of symbolic IP include brand names and logos.
The amendment also provides additional guidance on how restrictions included in an IP license arrangement might affect the number of performance obligations in a contract. That is, contractual provisions that require an entity to transfer control of additional rights during the license term should be distinguished from contractual provisions that define the attributes of a single promised license. So for example, a restriction that allows a customer to use IP in the US for the first year but then allows use of the IP in Europe starting in Year 2 would generally be viewed as two separate performance obligations because the entity must transfer the additional European rights at the beginning of year 2. Conversely, a restriction that the IP can only be used to sell products in the US during the license term would be viewed simply as an attribute of the license, and doesn’t impact the number of performance obligations. The FASB’s clarifications didn’t provide bright lines in this area so we expect that determining whether a restriction results in the transfer of additional rights or is an attribute of the license will likely require significant judgment.
There are two other amendments to the licensing guidance that I would like to mention. The FASB clarified that similar to the initial contract for a license, you can’t begin to recognize revenue prior to the start of the license period for a renewal. The FASB also clarified the scope and applicability of the sales or usage based royalty exception for both functional and symbolic licenses of IP. This exception says that when a royalty is promised in exchange for a license of IP, revenue should be recognized at the later of when the subsequent sale or usage occurs or the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). The Board clarified that guidance on sales and usage based royalties applies when the royalty relates only to a license of IP or when the license of IP is the predominant item to which the royalty relates.
The FASB didn’t provide a specific definition of predominance, but the Board noted that a license would likely be the predominant item when the customer would ascribe significantly more value to the license than to the other goods and services to which the royalty relates. Overall, the amendments to the licensing guidance are intended to reduce diversity in practice, make the guidance more operable, and reduce the cost and complexity of the accounting. However, companies will still be required to exercise significant judgment when applying this guidance.