Royalty Accounts Introduction, Types, Parties

Royalty Accounts refer to the accounting treatment for payments made by one party (the licensee or lessee) to another (the licensor or lessor) for the right to use assets like patents, copyrights, trademarks, natural resources, or land. The payments, known as royalties, are often based on a percentage of revenue or production. In accounting, royalty expenses are recorded by the lessee as an operating expense, while the lessor records it as income, reflecting the earnings from the agreement.

Types of Royalties:

1. Patent Royalties

Patent royalties are paid by a licensee to a patent owner for the right to use, manufacture, or sell products or services based on the patented technology. These payments are usually a percentage of revenue or a fixed amount per unit sold. Companies that want to avoid developing proprietary technologies often pay patent royalties to leverage existing innovations.

2. Copyright Royalties

Copyright royalties are paid for the use of creative works like books, music, films, and software. Writers, musicians, and content creators earn these royalties when their work is used by others, such as publishers, broadcasters, or digital platforms. The payments are often a percentage of revenue generated from sales, downloads, or streaming.

3. Trademark Royalties

Trademark royalties are payments for the use of a registered trademark or brand. Companies may license their brand names or logos to others in exchange for royalties, typically in industries like franchising or merchandising. This helps maintain brand identity while generating income for the trademark owner.

4. Natural Resource Royalties

These royalties are paid to the owners of land or mineral rights for extracting natural resources like oil, gas, minerals, or timber. The payments are usually based on the volume or value of resources extracted. This type of royalty is common in the energy, mining, and forestry sectors.

5. Franchise Royalties

Franchise royalties are recurring payments made by a franchisee to the franchisor for using the brand, operational systems, and business model. They are usually a percentage of the franchisee’s gross revenue.

Parties in Royalties Accounting:

1. Licensor (Lessor)

The licensor is the party that owns the asset or rights being licensed. This could be intellectual property like patents, copyrights, trademarks, or physical assets such as land, minerals, or oil resources. The licensor allows the licensee to use these rights or assets in exchange for a royalty payment. The licensor benefits by earning revenue without having to directly exploit the asset themselves.

Accounting Treatment for the Licensor:

The royalty payments received by the licensor are recorded as income in their books. This income is typically recognized based on the royalty agreement, which could involve a fixed percentage of sales, production, or output.

• The journal entry for royalty income for the licensor is:
  • Debit: Bank or Accounts Receivable (when the payment is due or received)
  • Credit: Royalty Income Account (for the amount earned)

If there are minimum guaranteed royalties (MGRs) in the agreement, the licensor records the minimum amount as income even if the actual royalties fall short of the agreed threshold. Adjustments can be made in future periods if royalties exceed the minimum.

2. Licensee (Lessee)

Licensee is the party that pays the royalties for the right to use the licensor’s asset or intellectual property. The licensee might use a patent to manufacture products, extract minerals from land, or distribute copyrighted content. The licensee benefits by gaining access to valuable assets or intellectual property without the need to develop or acquire them directly.

Accounting Treatment for the Licensee:

• The royalty payments made by the licensee are treated as an operating expense and are recorded in their books under a royalty expense account.
• The journal entry for royalty payments for the licensee is:
  • Debit: Royalty Expense Account (for the amount paid or due)
  • Credit: Bank or Accounts Payable (depending on when the payment is made)

Similar to the licensor, if there is a minimum royalty payment clause in the agreement, the licensee must record the payment of the minimum amount even if the actual usage or output does not generate sufficient royalties.

3. Other Potential Parties

In more complex royalty arrangements, there could be additional parties, such as sub-licensees (who acquire rights from the original licensee) or intermediaries involved in collecting and distributing royalties. However, the primary relationship is between the licensor and licensee.

Important Terms in Royalties Accounting:

1. Royalty

Royalty is a payment made by a licensee to a licensor for the right to use an asset, intellectual property (IP), or natural resource. Royalties are typically calculated as a percentage of revenue, sales, or production, or as a fixed payment per unit.

2. Licensor (Lessor)

Licensor is the owner of the asset or IP that is being licensed. The licensor receives royalty payments in exchange for allowing the licensee to use the asset.

3. Licensee (Lessee)

Licensee is the party that pays royalties to the licensor in exchange for the right to use the licensor’s asset or IP. The licensee records royalty payments as an operating expense.

4. Minimum Guaranteed Royalty (MGR)

MGR is a minimum amount that the licensee agrees to pay the licensor, regardless of the actual revenue or usage of the licensed asset. If royalties based on actual sales fall below the minimum amount, the licensee must still pay the MGR.

5. Advance Royalties

Advance royalties are payments made by the licensee in advance, often before any revenue or production occurs. These advances are typically recouped by deducting them from future royalty payments.

6. Recoupable Royalties

This refers to the arrangement where the licensee can recover advance royalty payments from future earnings generated by the asset or IP.

7. Royalty Rate

Royalty rate is the percentage or fixed amount used to calculate the royalty payments. It is often defined in the royalty agreement and can vary based on revenue, units sold, or resources extracted.

8. Dead Rent

Dead rent is a fixed minimum amount of royalty paid by a lessee (in case of natural resource extraction, like mining) even if the production is less than expected or zero.

9. Short-workings

Short-workings refer to the difference when the actual royalty calculated is lower than the minimum guaranteed royalty (MGR). The licensee may be able to carry forward this amount and adjust it against future royalty payments.

10. Normal and Abnormal Losses

In the context of royalties based on production, normal losses are expected losses during the extraction or production process, while abnormal losses are unexpected and beyond the usual course of business. These affect royalty payments, especially in industries like mining and oil extraction.

11. Royalty Expense

For the licensee, royalty expense represents the amount paid to the licensor as per the royalty agreement. This is recorded as an operating expense in the licensee’s financial statements.

12. Royalty Income

For the licensor, royalty income represents the earnings received from the licensee. This is recorded as revenue or income in the licensor’s financial statements.

13. Overriding Commission

An Overriding commission is an additional commission paid to a party, often an agent, for overseeing a royalty agreement or managing consignment or franchise sales. This is separate from the basic royalty or commission.

14. Sub-License

Sub-license occurs when the original licensee grants permission to a third party to use the licensed asset. The original licensor may receive additional royalties from such agreements.

15. Exploitation Rights

These are the rights granted by the licensor to the licensee to use, sell, or otherwise exploit the licensed property or asset.