Royalties refer to the payment paid in exchange for a license to issue a particular patented or copyrighted asset. Royalties involve two parties: the owner of the asset, also known as the licensor, and the other party that pays royalties in return for acquiring a license to it, also known as the licensee.
In royalties, the owner is not selling full legal ownership of the asset, but simply the right to manufacture it. If the rights to ownership of a property are sold, that would be called capital expenditure. This is how the two differ. There are actually three types of royalties in accounting, namely: Copyright, Patent, and Mining. For this article, we will focus on the first one.
Copyright refers to the legal right of a photographer or writer to his work, or general intellectual property. Royalty, in this case, is paid by the publisher to the photographer or the author based on sales. Mining Royalty means the amount payable of a lessee to a lessor in exchange for a lease in a mine or quarry. Patent royalty is paid based on the production of a particular product between lessee and lessor.
Royalty in accounting basically means that the proprietor of a particular product has the full legal right to ownership to it, take, for example, the author of a book. A publisher, to create, publish, and sell copies of the book to the mass audience, has to pay an agreed amount to the proprietor of the book. This is called royalties. In accounting terms, royalties refer to the amount periodically paid by the licensee to the licensor on the basis of sales and production.
Example of Royalty Payment Accounting
To better understand royalties and how it works, here are two examples:
- The writer of a book (licensor) must be paid royalties by the publisher (licensee) for the book to acquire the license to publish it.
- A game developer (licensor) will grant the license to use or release the game to a publisher (licensee) in exchange for royalties.
This royalty payment follows a two-step process. First, the licensee must pay an advance royalty payment to the licensor once an agreement between the two has been agreed and signed. Second, the licensor is eligible for a royalty on each copy that was sold, which is also called regular royalty payment.
As a case scenario, let’s say the publisher pays the advance royalty payment in exchange for acquiring the license to manufacture the asset, or in this scenario is a book. They agree on the value of $10,000. Consecutively, they agree that the licensor will be paid a regular royalty payment of $10 for each copy of the book that the licensee has sold. Since the licensor will earn $10 worth of royalty for each copy of the book sold, the advance royalty payment of $10,000 serves as a pre-payment to the 1,000 sold copies.
Regular Royalty Payments
The regular royalty payment is the second part of the deal between the licensor and the licensee that has to be followed so that the licensee can continue publishing the writer’s book. The pre-payment of $10,000 is listed on the balance sheet under the current asset.
Suppose, on the first batch of sales, and the publisher sells 600 copies of the book. This means that $6,000 (600x$10) under advance royalty payment is transferred to due royalty. $4,000 dollars are left on the prepaid royalties.
At the second batch of sales, the publisher sells another 600 copies of the book, which means another $6,000 of royalty. However, there is only $4,000 left on the advance royalty payment, which means that the publisher owes $2,000 worth of royalty to the books’ author.
Stepped Royalty Payments
To calculate the royalty due once the rate increases in succeeding batches of sales, follow this process.
In the initial agreement, the royalty was $10 for each copy. In the succeeding sales, the royalty due could increase to $12. In the third and last batch of sales, the publisher sells 500 copies of the book, which would make it $6,000 worth of royalty due.
Example of Royalty Income Accounting
For the licensor (writer of the book) to calculate how much royalty he is owed, we’ll take the above data and tally it.
Advance Royalties Income
Upon receipt of the advance royalty payment, the licensor lists it as stated below. Since the sales have not been made, the royalty hasn’t been earned yet. It is listed on the balance sheet under unearned royalties.
Regular Royalties Income
At the first batch of sales, the publisher sells a total of 600 copies. It means that the writer garnered $6,000 of royalty due.
At the second batch of sales, another 600 copies of the book were sold, earning the writer another $6,000 of royalties.
Since the total revenue for the second batch was $6,000, and there is an existing $4,000 balance on the unearned royalties, the writer is eligible for $2,000 worth of royalties receivable.