Royalty is what a lessee pays to a lessor for the use of any rights, copyrights, franchises or any such asset. It is the system of sharing of revenues between the lessee and the lessor. Let us learn more about the special accounting treatments in royalty accounts.
Royalty is payable by a user to the owner of the property or something on which an owner has some special rights. A royalty agreement is prepared between the owner and the user of such property or rights. If payment is made to purchase the right or property that will be treated as capital expenditure instead of a Royalty.
Payment made by the lessee on account of a royalty is normal business expenditure and will be debited to the Royalty account. It is a nominal account and at the end of the accounting year, balance of Royalty account need to be transferred to the normal Trading and Profit & Loss account. Royalty, based on the production or output, will strictly go to the Manufacturing or Production account. In case, where the Royalty is payable on sale basis, it will be part of the selling expenses.
Types of Royalties
There are following types of Royalties:
- Copyright: Copyright provides a legal right to the author (of his book/s), the photographer (on his photographs), or any such kind of intellectual works. Copyright royalty is payable by the publisher (lessee) of a book to the author (lessor) of that book or to the photographer, based on the sale made by the publisher.
- Mining Royalty: Lessee of a mine or quarry pays royalty to lessor of the mine or quarry, which is generally based on the output basis.
- Patent Royalty: Patent royalty is paid by the lessee to lessor on the basis of output or production of the respective goods.
Parties in Royalties Accounting
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 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.
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.
It can be presented in the following manner:
If the lessor or landlord agrees to compensate the losses which were incurred in the first few years (say, three or four years) the same is known as fixed, i.e., if any short-working falls beyond this period, the same cannot be reimbursed.
If the lessor or landlord agrees to compensate the loss which were incurred in the first few years, in the next or following or subsequent three or four years, the same is known as floating as the same can be adjusted in any year if short-working arises, i.e., each year’s short-working will have to be adjusted against the excess royalties earned in the subsequent years accordingly.
Students must remember in this respect that the short-workings which are not recovered within the stipulated period should be treated as irrecoverable, and, hence, should be transferred to Profit and Loss Account of the year in which the same is lapsed. The recoupable part of short-working is shown in the asset side of the Balance Sheet. Provision to be made for Short-workings
It has already been stated above that recoupable short-working appears in the assets side of the Balance Sheet as a current asset on the assumption that the same will be recouped in future. But it is uncertain. Sometimes, it may not be possible for the lessee to recoup the amount of short-working due to many factors although he has got the legal right to recoup.
From the standpoint of conservatism a provision should be made for such short-workings against Profit and Loss Account in that particular year when such short-working appears. It is needless to say that provisions for short-working will appear in the liabilities side of the Balance Sheet.
Whereas short-workings (recoupable) will appear in the assets side of the Balance Sheet. Consequently, un-recoupable part of the short-workings will be adjusted against such provision and not against Profit and Loss Account. The balance of provision, if any, should be credited to Profit and Loss Account.
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.
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