Sales and Usage based royalties – IFRS 15 Revenue from Contracts with Customers (contents page is here) introduced a single and comprehensive framework which sets out how much revenue is to be recognised, and when. Sales and Usage based royalties
The core principle is that a vendor should recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the vendor expects to be entitled in exchange for those goods or services. See a summary of IFRS 15 here. Sales and Usage based royalties
This section is part of step 3 determining the transaction price. When an entity earns royalties based on the extent to which a customer uses or benefits (through onward sales) from a license of Intellectual Property (IP), it has transferred control of the IP to its customer, with uncertainty over the amount of consideration (i.e. the consideration is variable).
As an exception to the general principles in IFRS 15 that revenue is recognised when control of a good or service has been transferred to a customer and measured at an amount to which it expects to be entitled, royalties earned from sales- or usage-based licenses of intellectual property are recognised only at the later of the following: Sales and Usage based royalties
- The subsequent sale or usage occurs; and Sales and Usage based royalties
- The performance obligation to which some or all of the sales- or usage-based royalty has been allocated has been satisfied (or partially satisfied).
The interaction of this restriction, and the requirement to consider stand-alone selling prices when allocating consideration to multiple performance obligations in a contract, can lead to patterns of revenue recognition which differ from amounts stated in contracts. Sales and Usage based royalties
This arises, for example, in cases where two or more licenses over intellectual property that are to be transferred to a customer at different times are included in a single overall contract, and the prices specified in the contract do not reflect the stand-alone selling prices of the licenses. Sales and Usage based royalties
The approach required by IFRS 15 is designed to ensure that the timing and profile of revenue recognition is not affected by what might be considered to be artificial price allocations in contracts.
The subsequent sale or usage occurs Sales and Usage based royalties
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||Year 2||Year 3||Year 4||Year 5|
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:
- CU1.5m for the licence of IP for 2 years
- Additional CU0.5m if customer makes sales of more than CU100m in the 2 years
- Additional CU1.0m if customer makes sale of more than CU200m in the 2 years.
In the above example, the entity will recognise revenue of CU1.5m when, or as, control of the licence passes, and the additional CU0.5m/CU1.0m in the period(s) that the customers’ sales exceed the cumulative CU100m / CU200m targets.