Let's talk about royalties in accounting

2. Accounting for royalties

Accounting for royalty arrangements may be challenging due to different royalty rates, possible reserves for returns, cash advances, “free” goods options and other individually agreed upon terms with owners of intellectual rights. Therefore, it is preferable to use services of specialists, such as royalty accountants to reduce the risk of misstatements in financial statements.

Some common journal entries are presented below.

Accounting for Advance Payments

For example, a licensing agreement requires a $1,000 advance royalty payment to intellectual property rights owner (licensor) when the licensing agreement is signed. The buyer (licensee) then posts:

Account Titles

Debit

Credit

Prepaid Royalty

$1,000

 

     Cash

 

$1,000

Periodic payments

Let us assume the subsequent royalty payment is 6% of net income of $10,000 paid quarterly. At the end of the quarter, royalties due are calculated by multiplying net income of $10,000 by 6%, which is $600 (Period 1). After the prepayment is exhausted, the licensee’s cash balance is credited (Period 2).

Period 1

Account Titles

Debit

Credit

Royalty Expense

$600

 

      Prepaid Royalties

 

$600

Period 2

Account Titles

Debit

Credit

Royalty Expense

$600

 

      Prepaid Royalties

 

$400

      Cash

 

$200

If there is a stepped royalty arrangement in place, for instance, with an author that stipulates $1 per book for the first 1,000 books but then steps up to $1.2 per book for subsequent sales, then sales of 1,500 books will result in $1,600 of royalties (1,000 x $1 + 500 x $1.2). The amount is accrued if the payment is going to take place after the end of the financial period.

Account Titles

Debit

Credit

Royalty Expense

$1,600

 

      Accrued Royalties

 

$1,600

Things get more complicated if royalty calculation prescribed by the contract relies on forecasts of future sales volumes to assess the correct stepped royalty rate to apply.

Impairment of royalty assets

Under current economic conditions, the risk of impairment of royalty assets has significantly increased due to rapid technological changes and highly competitive market conditions. For example, if the carrying amount of a royalty asset exceeds its recoverable amount by $100, then impairment is posted in the books of the intellectual rights owner (licensor).

Account Titles

Debit

Credit

Impairment Expense

$100

 

      Intellectual Rights

 

$100

Note that the buyer of intellectual rights (licensee) would simply stop selling non popular items, and as result no royalty payment will be needed and no accounting entries are expected to be posted in the books of the licensee (the buyer).

Early termination of royalty contracts

The accounting entry for royalty termination contracts should take into account all negotiated terms with the licensor, such as a reversal of advance payments, an amount of early termination fees etc. For example, if a company prepaid an author $2,000 on a non-recourse basis, book sales earned $2,500 of royalties, and parties agreed on a $700 early termination fees, then the company would post the following journal entry:

Account Titles

Debit

Credit

Early Termination Fees Expense

$700

 

Royalty Expenses

   $2,500

 

      Prepaid Royalties

 

$2,000

      Cash (balancing)

 

$1,200

Not a member?
See why people join our
online accounting course:
Lecture Contents:
Free Study Notes
Download free accounting study notes by signing up for our free newsletter (example):
First Name:
E-mail:
We never share or sell your e-mail to third parties.