IFRS 15 in the Spotlight: Variable consideration & the sales-based or usage-based royalty exception

In our November IFRS 15 article we considered the impact of variable consideration on revenue recognition and the requirement to estimate this consideration, subject to the variable consideration constraint. This article explains an exception to variable consideration treatment for certain licences of intellectual property (IP).

Where the variable consideration in relation to the licence (but not sale) of IP is in the form of a sales-based or usage-based royalty, ie the amount of consideration receivable is dependent upon the number of sales the customer makes using the IP, then that variable consideration is subject to different constraints.

This restriction only applies where the sales-based or usage-based royalty relates solely or predominantly to the IP licence such as may be the case with, for example, a licence for a movie for six weeks of screenings, along with providing memorabilia at the start of the screening period. In instances where the royalty relates solely or predominantly to the IP licence then the sales-based or usage-based royalty exception (the ‘royalty exception’) must be applied to the royalty in its entirety.

In these instances, instead of the ‘general approach’ to estimating the variable consideration amount, IFRS 15 only permits the recognition of the revenue from these sales-based or usage-based royalties when, or as, the later of the following occurs:

The subsequent sale or usage occurs, or
The performance obligation to which some or all of these royalties has been allocated has been satisfied (or partially satisfied).

The subsequent sale or usage occurs

This may require an element of estimation of sales/usage-based royalties where there is a timing difference between the sale or usage occurring, and when these reports by the customer are received by the licensing entity.

Satisfaction of performance obligation

The purpose this test is to prevent the acceleration of revenue recognition before an entity has performed the obligation. This is because the royalty exception applies to the restriction of variable consideration that can be recognised, but doesn’t over-ride the underlying requirements of IFRS 15 that where revenue is recognised over time, the measurement depicts an entity’s performance in transferring control of the goods or services.

Example – recognition restricted to satisfaction of performance obligation

An entity licences IP to a customer for five years, and determines that revenue is to be recognised over time. The royalty exception applies because the payment schedule sets out that the amount billed is at the following royalty rates on the customers’ sales: Year 1: 10%, Year 2: 8%, Year 3: 6%, Year 4: 4% Year 5: 2%.

The entity estimates that:

The customer sales on which the royalty is based will be approximately equal for each of the five years under licence, and
Any activities undertaken by the entity affecting its IP will be performed on an even and continuous basis throughout the licence period.

Should the entity recognise the royalty revenue based upon contractual terms?

Following the legal form of the royalty might not appropriately depict progress in satisfying its performance obligation for providing access to the entity’s IP as it may exist from time to time throughout the licence period.

Although the royalty exception sets a limit on the maximum amount of revenue that might be recognised, this does not mean that this maximum amount should always be recognised. The entity may therefore need to defer some of this revenue to satisfy the second test within the royalty exception recognition criteria. In practice, in the scenario above, this might be done by applying an average expected royalty rate to calculate the revenue deferral.

When does this exception apply?

The term ‘royalty’ is not defined within the standards, and care must be taken when determining whether the royalty exception applies in certain payment structures which may be ‘in-substance’ sales or usage-based royalties (for example, milestone payments).

An example of this would be where a company licences IP with a payment structure as follows:

£1.5m for the licence of IP for 2 years
Additional £0.5m if customer makes sales of more than £100m in the 2 years
Additional £1.0m if customer makes sale of more than £200m in the 2 years.

In the above example, the entity will recognise revenue of £1.5m when, or as, control of the licence passes, and the additional £0.5m/£1.0m in the period(s) that the customers’ sales exceed the cumulative £100m / £200m targets.

What if the contract includes a minimum royalty guarantee?

Often, licence of IP contracts can include a fixed element and a royalty based element, such as a sales-based royalty payment plan with a minimum royalty guarantee of £2m.

The minimum royalty guarantee element would not be subject to the royalty exception, as it does not form part of the variable consideration, and so would be recognised when, or as, control of the licence is passed to the customer. Any additional sales-based or usage-based royalties in excess of this guaranteed minimum would be subject to the royalty exception and recognised in the period that the sales/usage occurs.

Where the licence of the IP is recognised at a point in time, the guaranteed minimum amount is recognised at that point in time, with any excess royalties recognised once the sales/usage that take the royalties above the guaranteed minimum occur.

Where the licence of the IP is recognised over time, more judgement is required by management as they will need to determine an appropriate measure of progress. Regardless of the measure of progress selected, cumulative revenue at any point in time must not exceed the sum of minimum guaranteed royalties plus excess royalties earned to date.

For help and advice on revenue recognition issues please get in touch with your usual BDO contact or Scott Knight.