Sales-Based Royalties: Revenue Recognition Under ASC 606

Understanding how to properly recognize sales-based royalties under ASC 606 is crucial for many businesses, especially in franchising and licensing industries. Whether you’re a franchisor collecting royalties from restaurant franchisees or a biotech firm licensing intellectual property, knowing the nuances of ASC 606 can help you stay compliant and optimize your revenue reporting.

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Why Understanding Sales-Based Royalties Under ASC 606 Matters?

Revenue recognition is more than just clicking boxes; it is about correctly capturing the economic realities of your company's activities. Sales-based royalties often represent a significant portion of revenue for franchisors and licensors. Misapplying ASC 606 rules can lead to misstated financials, regulatory scrutiny, and even costly restatements.

ASC 606, the revenue recognition standard under U.S. GAAP, sets out a five-step model that businesses must follow. Sales-based royalties, however, have special considerations within this framework that require careful attention.

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What Are Sales-Based Royalties?

Simply put, sales-based royalties are payments calculated as a percentage of sales or usage of a product or service. They are common in agreements where one party licenses intellectual property (IP) or a brand to another.

Common examples include:

• A restaurant franchise pays the franchisor 5-8% of its total monthly income.
• A pharmaceutical company licensing a drug formula and earning royalties based on drug sales.
• A technology firm licensing patented software and receiving royalties based on units sold.

These royalties are variable consideration because the amount received depends on the licensee’s sales performance.

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Why Do Sales-Based Royalties Require Specific Treatment Under ASC 606?

Unlike fixed fees, sales-based royalties depend on future sales or usage, making revenue recognition more complex. ASC 606 requires that revenue from these royalties be recognized only when the related sales or usage occur — not upfront or on contract signing.

For example, a franchisor earning 6% royalty on monthly gross sales recognizes revenue monthly when franchisees report sales, not when the franchise agreement is signed. Similarly, a biotech company licensing IP recognizes royalty revenue only after receiving confirmed sales data from its licensee.

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The Five-Step Model Under ASC 606

ASC 606 establishes a clear five-step process for revenue recognition:

1. Identify the contract with a customer: Ensure that a genuine and enforceable agreement exists.
2. Identify the performance obligations: Determine what goods or services you must deliver.
3. Determine the transaction price: Calculate the amount you expect to receive, including variable consideration like royalties.
4. Distribute the transaction money to the performance responsibilities: Assign the transaction price to each obligation based on relative standalone selling prices.
5. Recognize income when performance commitments are met: For sales-based royalties, this typically means recognizing revenue when the underlying sales occur.

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Conditions for the Royalty Exception Under U.S. GAAP

ASC 606 makes an exception for sales-based royalties associated with intellectual property licensing. To qualify:

• The royalty must be explicitly linked to subsequent sales or usage by the licensee.
• The royalty must be distinctly associated with a license of intellectual property.

If these requirements are met, revenue recognition is postponed until either the sale or usage happens or the royalty performance obligation is met.

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Real-World U.S. Examples

Franchise Example:

A U.S. restaurant franchisor earns a 6% royalty on monthly gross sales from franchisees. Revenue is recognized monthly when sales reports are submitted, reflecting actual sales, not at contract signing.

Biotech Licensing Example:

A U.S. drug developer licenses IP to a global pharmaceutical company with a 4% sales royalty. Revenue is recognized only upon confirmation of sales data, ensuring accuracy and compliance.

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Common Pitfalls and Mistakes in the U.S. Market

• Treating sales-based royalties as fixed fees: This can lead to premature revenue recognition.
• Recognizing royalty revenue upfront: Violates ASC 606 and can trigger audit issues.
• Ignoring contract nuances: Hybrid agreements with minimum guarantees or other terms can affect classification and timing.
• Lack of proper sales data tracking: Without reliable sales reporting from licensees or franchisees, revenue recognition becomes guesswork.

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U.S. Disclosure Requirements Under ASC 606

Companies must disclose:

• The nature of performance obligations related to royalties.
• Significant judgments made in recognizing revenue.
• Details about variable consideration and any constraints applied.

These disclosures provide transparency to investors and regulators about how royalty revenue is recognized.

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Compliance Best Practices for U.S. Companies

• Maintain clear contracts: Define what constitutes sales or usage-based royalties explicitly.
• Implement robust tracking systems: Regularly reconcile sales data from franchisees or licensees.
• Coordinate across departments: Accounting, finance, and legal teams should work closely to interpret contracts and apply ASC 606 correctly.
• Prepare for audits and SEC reviews: Especially important for public companies to avoid surprises.

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How QMK Consulting Can Help

If you’re a franchisor or licensor navigating ASC 606 sales-based royalty recognition, QMK Consulting offers specialized accounting expertise tailored to your industry. Based in New York City, we focus exclusively on franchise accounting — not franchise audits — helping you stay compliant while optimizing your financial reporting.

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Ready to Optimize Your Franchise Accounting?

Book a free profit and cash flow analysis with Mohamed Karmous, our franchise accounting expert and restaurant accounting advisor. Let us help you uncover opportunities to improve profitability and cash flow while ensuring ASC 606 compliance.

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