2020-02-11 09:12:44Accounting & TaxesEnglishThis article talks about Royalties Accounting, important terms related with Royalty accounts and Royalty Accounting treatment.https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2020/02/Royalties-Accounting-Meaning-Accounting-Treatment-and-Examples.jpghttps://quickbooks.intuit.com/in/resources/accounting-taxes/royalties-accounting/Royalties Accounting: Meaning, Accounting Treatment & Examples

Royalties Accounting: Meaning, Accounting Treatment & Examples

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Royalty is a consideration received by business entities or individuals who sell their creations to a third party for use. Typically, royalty is considered to be synonymous with rent, however its concept and application varies completely.

Although, the user of asset pays consideration to the owner for using the owner’s asset both in the case of acquiring a property on rent or a book for publishing. However, royalty is different from the rent paid by the user.

Where rent is paid for using tangible assets like building, machinery etc, royalty is paid for using intangible assets or availing special rights such as patents, copyright, mines etc.

Furthermore, the amount of rent paid by the user is fixed. Whereas royalty paid by the user to the owner varies based on the quantity of goods produced or sold.

This article talks about Royalties Accounting, important terms related with Royalty in final accounts, Royalty Accounting treatment and Types of Royalties in Accounting.

Royalty Meaning in Accounting

Royalty is nothing but a periodical payment made by the user of the asset to the owner or the creator of such an asset for its use. In other words, the owner/author of the asset such as mine, patent, book, artistic work etc. may allow the third party like licensee, publisher etc to use its creation in exchange of a consideration.

Thus, such a payment made by the user to the owner is known as Royalty. Furthermore, the consideration paid in lieu of using the asset of the owner is determined in terms of the number of items produced or sold.

Parties in Royalties Accounting

  • Lessor

The person who creates or owns the asset and provides the right of using such an asset to the third party is known as the lessor or the landlord. Furthermore, lessor receives consideration from the third party for using the rights to use his asset.

Examples of lessors include owner of the mine or quarry, author of a book, artist in case of a music composition etc.

  • Lessee

Lessee is the person who uses the asset of the creator or the owner in lieu of a consideration for using such an asset. Examples of Lessees include publishers, miners etc.

Types of Royalties in Accounts

There are following types of royalties in accounting. These include:

  • Copyrights

Copyright provides the right to the author or owner of assets like book, artwork, music composition etc. to claim royalty from the publisher. Therefore, publishers pay copyright royalty to the author based on sales made by the publishers.

  • Patent Royalty

Patent Royalty is paid by the user to the owner based on the number of items produced.

  • Mining Royalty

In case of Mining Royalty, the user or the lessee pays royalty to the owner or the lessor based on the output produced.

Therefore, in case of a patent or a copyright, the publisher pays royalty to the author based on the number of book copies sold. In other words, the holder of the patent or copyright receives royalty based on the number of items sold by the user.

Whereas, in case of mining, the royalty is received by the owner of the mine based on the number of items produced by the user.

Important Terms in Royalties Accounting

  • Minimum Rent

As mentioned above, the lessor enters into a contact or an agreement with the lessee for the payment of royalty. This royalty is determined on the basis of number of goods produced or quantum of goods sold.

Now, there can be cases when the number of goods produced or sold are nill or relatively low. In such a case, the lessor would receive no or little royalty directly impacting lessor’s royalty income.

In other words, when there is no or little production or sale, the lessor would be at a loss since no or less amount of royalty would be received from the lessee. This is despite lessee using the asset.

To get rid of such a situation, the lessor requires a minimum amount of payment to be paid by the lessee irrespective of the number of goods produced or sold by the lessee.

That is, lessee is required to pay minimum amount to the lessor. This is despite the fact that the actual royalty amount, which is calculated based on the items produced or sold, is less than the minimum rent to be paid.

Such a guaranteed minimum amount so received by the lessor is called the minimum rent. Minimum rent is fixed at the time when the lessor enters into an agreement with the lessee.

It is a term included in the contract in the interest of the landlord as it assures minimum rent even in cases of lower sales or output. Therefore, the lessee pays minimum rent or the actual royalty amount, whichever is higher.

Since, the amount of minimum rent to be paid is fixed, it is also known as Fixed Rent or Dead Rent. This can however vary depending upon the terms of the agreement.

Example

For example, say the output produced by Mine A is 4,000 tons. The royalty to be paid by the lessee is Rs 100 per ton and the minimum rent in the agreement is Rs 5 Lakhs.

As per production, the actual royalty amount to be paid comes at Rs 4 Lakhs. Since the actual royalty amount is less than the minimum rent, the lessee is required to pay minimum rent of Rs 5 Lakhs to the Lessor.

  • Short Workings or Redeemable Dead Rent

Short Workings is nothing but the amount by which the minimum rent is more than the actual royalty. In other words, short workings is the difference between minimum rent and actual royalty.

In the example above, the Short Workings amount to Rs 1 Lakh (5 Lakh – 4 Lakh). It must be noted that Short Workings comes into picture only when the clause of minimum rent is included in the agreement.

  • Excess Working

Excess Working is nothing but the amount by which Actual Royalty is more than the minimum rent.

Say for instance, in the example above, the output produced is 6000 tons. Accordingly, excess working comes out to be Rs 2 Lakhs (6 Lakh – 4 Lakh).

  • Recoupment of Short Workings

Typically, the agreement entered by the lessor and the lessee under Royalty Accounting provides for a provision. This provision allows carry forward of short workings in order to adjust the same in future.

Therefore, in the following years Short Workings is adjusted against the excess royalty amount. Such a process of adjusting Short Working capital is known as recoupment of Short Workings.

In other words, the clause of recoupment in Royalty Agreement provides the right to the lessee to recover excess payment made by him to the lessor for complying with the clause of minimum rent in the previous years.

Furthermore, a time period is stipulated in the agreement. Such a period lays down the number of years during which Short Workings can be recouped or recovered by the lessee. This time period can be fixed or fluctuating.

In cases where the lessee fails to recover the Short Workings within the stipulated time, the Short Workings lapse and is debited to the P&L Account for the period in which the recoupment lapses.

  • Fixed Right

Fixed Right means that the lessee can recover short working from the lessor within a particular time period from the date of lease of the asset.

For instance, as per fixed right, say the lessee can recover Short Workings within 2 years from the date of lease. In case he fails to do so, the recoupment lapses or ends.

  • Fluctuating Right

Under Fluctuating Right, the lessee can recover Short Workings for any period during the subsequent period or periods. For instance, Short Workings of the previous year can be recovered in the subsequent year.

  • Strike and Lockout

There can be cases where a strike or a lockout takes place during the period of the Royalty Contract. Thus, the Royalty Agreement can provide for a provision that the minimum rent would be reduced proportionately in case a strike or a lockout takes place.

Royalties Accounting Treatment

There can be three types of circumstances in which both lessor and the lessee would be required to pass journal entries. Let’s understand Royalties Accounting Treatment with the help of an example.

Royalties Accounting Example

Zen is the owner of Mine A located in Gujarat. He enters into a Royalty Agreement with Kapoor Ltd. As per the agreement, the Minimum Rent is Rs 5,00,000 and the Royalty amount to be paid is Rs 100 per ton of production every month. The output in various years is as follows:

  • 2017 – 4000 tons
  • 2018 – 5000 tons
  • 2019 – 6000 tons

1. Royalties Accounting Entries in Books of Lessee

  • Case-I: When Minimum Rent Exceeds Actual Royalty Amount (2017)
1. When Royalty is Due
Royalties A/c Dr4,00,000
Short Workings A/c Dr1,00,000
To Zen A/c5,00,000
(Being Royalty and Short Workings due to Zen)
2. Entry for Making Payment
Zen A/c Dr5,00,000
To Cash/Bank A/c5,00,000
(Being cash paid to Zen)
3. Closing Entry at the Year End
P&L A/c Dr5,00,000
To Royalty A/c5,00,000
(Being Royalty transferred to P&L A/c)
  • Case-II: When Minimum Rent Equals Actual Royalty Amount (2018)
1. When Royalty is Due
Royalties A/c Dr5,00,000
To Zen A/c5,00,000
(Being Royalty due to Zen)
2. Entry for Making Payment
Zen A/c Dr5,00,000
To Cash/Bank A/c5,00,000
(Being cash paid to Zen)
3. Closing Entry at the Year End
P&L A/c Dr5,00,000
To Royalty A/c5,00,000
(Being Royalty transferred to P&L A/c)
  • Case III: When Actual Royalty Amount is More Than Minimum Rent and Short Working is Recouped (2019)
1. When Royalty is Due
Royalties A/c Dr6,00,000
To Zen A/c6,00,000
(Being Royalty due to Zen)
2. Entry for Making Payment and Recouping Short Working
Zen A/c Dr6,00,000
To Cash/Bank A/c5,00,000
To Short Working A/c1,00,000
(Being cash paid to Zen and Short Working Recouped)
3. Closing Entry at the Year End and Short Working Unrecouped
P&L A/c Dr6,00,000
To Royalty A/c5,00,000
To Short Working A/c1,00,000
(Being Royalty and Short Working transferred to P&L A/c)

 

As per the terms of the agreement, Short Workings can be recovered in the year in which actual royalty exceeds minimum rent. In case, lessee fails to recover Short Working in the specific period, it becomes irrevocable and is charged to P&L in the year in which the Short Working recoup lapses.

On the other hand, Short Working that can be recovered must be carried forward and shown as current asset in the balance sheet.

2. Royalties Accounting Entries in Books of Lessor

  • Case-I: When Minimum Rent Exceeds Actual Royalty Amount (2017)
1. When Royalty is Due
Kapoor Ltd5,00,000
To Royalties A/c4,00,000
To Short Workings A/c1,00,000
(Being Royalty and Short Workings to be received from Kapoor Ltd)
2. Entry for Making Payment
Cash/Bank A/c Dr5,00,000
To Kapoor Ltd5,00,000
(Being cash received from Kapoor Ltd)
3. Closing Entry at the Year End
Royalty A/c Dr5,00,000
To P&L A/c5,00,000
(Being Royalty credited to P&L A/c)
  • Case-II: When Minimum Rent Equals Actual Royalty Amount (2018)
1. When Royalty is Due
Kapoor Ltd5,00,000
To Royalties A/c5,00,000
(Being Royalty received from Kapoor Ltd)
2. Entry for Making Payment
Cash/Bank A/c Dr5,00,000
To Kapoor Ltd5,00,000
(Being cash received from Kapoor Ltd)
3. Closing Entry at the Year End
Royalty A/c Dr5,00,000
To P&L A/c5,00,000
(Being Royalty credited to P&L A/c)
  • Case III: When Actual Royalty Amount is More Than Minimum Rent and Short Working is Recouped (2019)
1. When Royalty is Due
Kapoor Ltd6,00,000
To Royalties A/c6,00,000
(Being Royalty received from Kapoor Ltd)
2. Entry for Making Payment and Recouping Short Working
Cash/Bank A/c Dr5,00,000
Short Working A/c Dr1,00,000
To Kapoor Ltd6,00,000
(Being cash received from Kapoor Ltd and Short Working Recouped)
3. Closing Entry at the Year End and Short Working Unrecouped
Royalty A/c Dr5,00,000
Short Working A/c Dr1,00,000
To P&L A/c6,00,000
(Being Royalty credited to P&L A/c and Short Working transferred)
Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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