Defining Issues. FASB Proposes Clarifications to License and Performance Obligation Guidance for Revenue. May 2015, No

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1 Defining Issues May 2015, No FASB Proposes Clarifications to License and Performance Obligation Guidance for Revenue The FASB has invited constituents to comment on a proposed Accounting Standards Update (ASU) intended to clarify the guidance on accounting for licenses of intellectual property and identifying performance obligations. 1 The comment deadline is June 30, The IASB plans to wait until substantially all of the potential amendments to its version of the standard have been discussed before issuing any exposure draft. 2 Key Facts The proposals in the exposure draft: Clarify when a performance obligation to transfer a license of intellectual property (IP) would be satisfied over time and when it would be satisfied at a point in time. Contents Determining the Nature of an Intellectual Property License... 2 Applying the Sales- and Usagebased Royalties Exception... 2 Other Clarifications on Licenses... 3 Identifying Promised Goods or Services... 3 Distinct in the Context of the Contract... 4 Accounting for Shipping and Handling Services... 4 Clarify when the sales and usage-based royalty exception to measuring variable consideration would be applied to a bundle of goods or services that includes a license of IP. Provide guidance on how restrictions on the use of a license of IP should be evaluated in determining the performance obligations in a license arrangement. Amend the guidance on evaluating whether goods or services are distinct in the context of the contract when identifying performance obligations in a contract. Add a policy election for accounting for shipping and handling services provided after control of the goods transfers to the customer. Key Impacts Companies should consider responding to the exposure draft. For entities that license IP, the amount or timing of revenue recognition may be significantly affected by the proposal. 1 FASB Proposed Accounting Standards Update, Identifying Performance Obligations and Licensing, May 12, 2015, available at 2 IASB IFRS 15, Revenue from Contracts with Customers.

2 Determining the Nature of an Intellectual Property License The revenue recognition standard provides implementation guidance on whether the consideration for a distinct license of IP is recognized as revenue over time or at a point in time. 3 A license that provides a right to access the entity s IP throughout the license period (or its remaining economic life, if shorter) results in revenue recognition over the term of the license. A license that provides a right to use the entity s IP as it exists at a point in time results in revenue recognition at the point in time when control of the license transfers to the customer. The proposed ASU would amend the implementation guidance on licenses of IP to require an entity to classify them into one of two categories. Functional IP. The customer derives a substantial portion of the benefit from the IP s stand-alone functionality. Functional IP would generally include software, biological compounds, drug formulas, and completed media content (e.g., films, television shows, and music). Consideration for functional IP would generally be recognized as revenue at the point in time when control of the IP transfers to the customer. However, if the functionality of the IP is expected to substantively change during the license period as a result of activities of the entity, and the customer is contractually or practically required to use the updated IP, then the consideration would be recognized as revenue over time. Symbolic IP. This does not have significant stand-alone functionality, and substantially all of the benefit to the customer is derived from its association with the licensor s past or ongoing activities. Consideration for symbolic IP would be recognized as revenue over the license period using a measure of progress that reflects the licensor s pattern of performance. Symbolic IP would generally include brands, trade names such as sports team logos, and franchise rights. The proposed ASU includes a flowchart to assess whether IP is functional or symbolic, and whether revenue would be recognized at a point in time or over time. Applying the Sales- and Usage-based Royalties Exception The revenue recognition standard includes an exception to the guidance on estimating variable consideration by specifying that an entity can only recognize revenue for a sales- or usage-based royalty for a license of IP at the later of (a) when the subsequent sale or usage occurs or (b) the performance obligation has been satisfied or partially satisfied. 3 FASB Accounting Standards Update No , Revenue from Contracts with Customers, available at 2

3 When a license of IP includes other goods or services, the proposed ASU would clarify that the royalty in its entirety either qualifies or does not qualify for the royalties exception and therefore the royalty would not be allocated among the performance obligations in the arrangement. The royalties exception would apply when the license of IP is the predominant item to which the royalty relates. The FASB acknowledged that determining when a license is the predominant item would require judgment. In general, we expect that a license would be considered to be the predominant item when the customer ascribes significantly more value to the license than to other goods or services in the arrangement. Other Clarifications on Licenses When to Determine the Nature of an Intellectual Property License The proposed ASU states that when a license of IP is not distinct from other goods or services in a contract, it may be necessary to determine the nature of the license to determine whether the performance obligation is satisfied over time or at a point in time. For example, if a license is bundled with goods or services that are provided over a period shorter than the license term, an entity would consider the nature and term of the license when determining the pattern for revenue recognition of the bundled arrangement. Contractual Restrictions The proposed ASU also specifies that contractual restrictions on time, geography, or a licensee s ability to use or access the underlying IP are attributes of the license and would not impact the number of performance obligations in the contract. These restrictions define the scope of the license rather than the number of licenses in the arrangement. For example, a license that allows a television station to broadcast a movie on four specific dates during the license term would be a single performance obligation. However, the proposed ASU also states that some contractual restrictions are not restrictions on the licensee s ability to use or access the IP. For example, if the licensee has the right to use or access the IP for two distinct periods of time, the period between the license periods is substantive, and the licensor grants the right to use or access the IP to another party during that intervening period, then the contract might include more than one performance obligation. Identifying Promised Goods or Services The first step in identifying performance obligations is to identify the goods or services promised in the contract. The standard states that promised goods or services are not limited to the goods or services that are explicitly stated in the contract. Rather, the contract with a customer may include promises that are implied by an entity s customary business practices, published policies, or specific statements if, at the time of entering into the contract, those promises create a valid expectation of the customer that the entity will transfer goods or services to the customer. However, administrative tasks an entity must undertake to fulfill a contract that do not transfer goods or services to the customer are not performance obligations. 3

4 The proposed ASU specifies that an entity is not required to identify goods or services to be transferred to the customer that are immaterial in the context of the contract. This guidance was proposed by the Board in an attempt to make implementation of the revenue standard less costly for some preparers. Distinct in the Context of the Contract The process of identifying performance obligations requires an entity to determine which goods and services are distinct. A good or service is distinct if the customer can benefit from it on its own or with other resources that are readily available to the customer (capable of being distinct) and the promise to transfer the good or service is separately identifiable (distinct in the context of the contract). While the first criterion is similar to the stand-alone value notion that exists in current U.S. GAAP, the second criterion is new. 4 The proposed ASU would amend the guidance on distinct in the context of the contract by: Providing explanatory language to better articulate the principle. The proposed language indicates that the objective when considering whether promised goods or services are separately identifiable is to determine whether the nature of the entity s overall promise in the contract is to transfer (a) each of those separate goods or services or (b) a combined item (or items) to which the promised goods or services are inputs. Amending the factors for determining what is distinct in the context of the contract. The factors would be amended in an attempt to more closely relate to the separately identifiable principle. In addition, the factors would refer to the goods and services in the contract as a bundle to focus the analysis on when goods or services significantly affect each other. Adding more examples to demonstrate how the separation guidance should be applied. Accounting for Shipping and Handling Services An entity may bill a customer for shipping and handling services in addition to the stated price of the goods or services. Unlike current U.S. GAAP, the revenue recognition standard does not provide specific guidance for the presentation of shipping and handling when an entity charges separately for them. 5 However, it defines the transaction price as the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer. 4 FASB ASC paragraph (a), available at 5 FASB ASC paragraphs , available at 4

5 Some stakeholders believe that shipping can be a promised service in the contract because the entity is providing a service of transporting the customer s asset to a location designated by the customer when transfer of control over the goods occurs before delivery (e.g., a freight-on-board shipping point arrangement). Other stakeholders believe that shipping the goods is a fulfillment activity that supports the transfer of control of the goods to the customer. They view shipping and handling no differently than other fulfillment costs such as procuring inventory and manufacturing the goods. Because shipping and handling is not considered a deliverable under existing U.S. GAAP, a conclusion that shipping and handling is a promised service in some arrangements could be a significant change in practice for some entities. The proposed ASU would provide a policy election that would allow entities to choose to account for shipping and handling either as a fulfillment cost or as a promised service when transfer of control over the goods occurs before the entity ships the goods. For example, an entity sells a product to a customer and ships the product with terms FOB shipping point. The entity concludes that it transfers control of the goods prior to shipping them. The entity could elect to treat the shipping as a separate performance obligation. This would result in recognizing revenue allocated to the goods when they are shipped, and revenue allocated to the shipping as the shipping takes place. Alternatively, the entity could elect to treat the shipping as a fulfillment cost. This would result in all of the revenue being recognized when the goods are shipped. In either case, the FASB agreed that the cost of shipping and handling that occurs prior to the customer obtaining control of the goods is a fulfillment cost. Contact us: This is a publication of KPMG s Department of Professional Practice Contributing authors: Brian K. Allen, Prabhakar Kalavacherla, Paul H. Munter, Brian J. Schilb, and Ryan N. Marquez Earlier editions are available at: Legal The descriptive and summary statements in this newsletter are not intended to be a substitute for the potential requirements of the proposed standards or any other potential or applicable requirements of the accounting literature or SEC regulations. Companies applying U.S. GAAP or filing with the SEC should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues is a registered trademark of KPMG LLP. 5