Licensing of Intellectual Property: Practical Application of IFRS 15 'Revenue from Contracts with Customers'

(updated v3: 24 January 2025)

(606: GAAP codification area for revenue from contracts from with customers; close harmonisation)

BACKGROUND

A seller of products or services may offer a license to a customer for the use of an intellectual property ("IP") that the seller owns. The IP can be patents, trademarks and copyrights (note: trade secrets are IP too but these are not licensed). We can apply the IFRS 15 five-step model to recognise the revenue within a licensing agreement.

THE FIVE-STEP MODEL

1. Identify the contract with a customer.

There must be a signed and dated licensing agreement with a customer. Distinguish if the license is a point in time (no update to the license) or over a period of time (license updated regularly; customer stands to benefit) for disclosure.

2. Identify the performance obligations in the contract.

Sales of products or services to a customer, royalty from customer on further sales of products or use of services with IP to third-party, minimum guaranteed income overlapping several periods and reimbursement of set-up costs to the seller. Performance obligations can be inferred to usual business practice but these are rare.

3. Determine the transaction price.

Establish the standalone price of each product or service sold (estimate if the standalone price cannot be derived), discount* the minimum guaranteed income over several period, if applicable, to present value, which is akin to cash paid by the customer to use the IP on the date of the licensing agreement, calculate royalty based on an agreed percentage rate for each product or service sold to third parties as shown in the customer's records and look for the set-up costs. Variable consideration is rarely seen in a typical licensing agreement.

(* Minimum guaranteed income paid over several periods indicates a financing component in the transaction price even though this is not explicit in the licensing agreement. Discount rate is based on the characteristics of the customer, including collateral but we can use the seller's loan facility rate as a good estimate. The difference between the minimum guaranteed income and the cash selling price is the interest income or unwinding of discount for the seller. The discount rate is not updated after the agreement begins.)

4. Allocate the transaction price to the performance obligations in the contract.

Sales of products or services to a customer - total actual or estimated standalone price of all products or services

Minimum guaranteed income - discounted cash selling price

Royalty - total of each royalty from every product or services sold to third parties by the customer

Set-up costs - amount stated in the agreement

5. Recognise revenue when (or as) the entity satisfies a performance obligation

Date to recognise revenue:

• Seller has the right to receive payment
• Customer has legal title to the assets transfer
• Seller has transferred physical possession
• Customer has taken on significant risks and rewards
• Customer accepts the asset
• Customer can prevent others from using the asset

Performance obligations can be transferred over time, instead of at a point in time, such as construction and software development contracts. Criteria for revenue recognition for these contracts are: immediate use, immediate enhancement and no alternative use.

DISCLOSURES

Income Statement

Sales of products or services

Minimum guaranteed income

Royalty

Interest income from unwinding of discount

(aggregate vs disaggregate, timing: over a period vs at a point in time, type of revenue, geography, etc)

Balance Sheet

• Contract asset (or minimum guaranteed income receivable) - revenue recognised but not invoiced (subject to Impairment IAS 36; under or over 1-year)
• Contract liabilities - unpaid suppliers' invoices (very rare for licensing contracts; under or over 1-year)
• Receivables - amount invoiced but not paid by customer (subject to provision under IFRS 9 Financial Instruments)

PRACTICAL ISSUES

Modification of licensing agreement - distinguish between separate agreement (distinct change, price change) versus continuing agreement (residual obligation under old agreement; surplus or deficit against current year's revenue and contract asset balance). Consider materiality.

Lumpy licensing revenue - IFRS 15 recognises as revenue the minimum guaranteed income from future years upfront at present value on the Income Statement with the corresponding entry in contract asset, or receivable after invoicing, on the Balance Sheet. When royalties are paid in later years, they are first set off against the Balance Sheet. Excess will flow to the Income Statement. This makes year-on-year comparison, budgeting and forecasting of licensees' performance tricky as licensing agreements with material minimum guaranteed income can skew financial results. Therefore, keep 2 licensing tables - IFRS 15 and performance - and perhaps have a licensing database - to manage this issue.

Too much focus on financial clauses -non-financial clauses are often overlook and obligations not enforced until it is too late. Use independent auditors to perform rotational licensing audits on high-value and risky licensees. A typical licensing agreement will include clauses giving the licensor the right to audit the licensee and having the licensee to bear the audit costs if the audit finds errors above a certain threshold.

Too many small licensees - while every pound matters, the time and effort needed to manage and nurture a ￡1,000,000 licensee is less than ten ￡100,000 licensees. Having many small licensees distracts the focus on the larger licensees and IP-nurturing activities, resulting in lack of thorough review of licensed products, failure to monitor product development, failure to track launch programme of licensees and reduced opportunity for closer collaboration, all of which are harmful to IP valuation either in an impairment review or a sale of IP situation.

EXEMPTIONS

Some transactions are excluded from this standard:

Leasing (IFRS 16)

Insurance (IFRS 17)

Financial instruments (IFRS 7, IFRS 9, IAS 32 and IAS 39)

Non-monetary exchanges between two entities

Disclosures exemptions (amendments to FRS 101)

For more details, refer to the following sources:

IFRS 15 'Revenue Recognition from Contracts with Customers'

IFRS Guidebook - Steven M. Bragg

GAAP Guidebook - Steven M. Bragg

Revenue - IFRS Handbook - KPMG