Let's talk about royalties in accounting

3. Preventing “creative accounting”

Inherent complexity of the royalty contracts, limited detailed guidance for the parties of royalty arrangements coupled with moving to digital transactions and development of new patterns of carrying busyness require more judgement from accounting and finance professionals.

In order to increase the quality of financial reporting related to royalties, the following controls may be justifiable:

1) Verification of proper payments in accordance with contract terms, including non-monetary conditions such as no royalty payments in periods when sales targets are not met or application of increased royalty rates to overseas sales.  Timely and accurate royalty payments mitigate the risk of being sued and reduce subsequent legal expenses.

2) Checking completeness and relevance of income streams used as the basis for royalty calculation, for instance, verifying that all income streams from different branded merchandise possessing the same logo are included in the computations.

3) Making annual assessment of Royalties Receivable balances for recoverability and posting necessary Royalties Receivable Allowances against uncollectable amounts, as otherwise income of the company may be overstated.

4) Verification that royalty income is reported net of related royalty expenses, for example, a video game publisher should present its royalty income net of royalties charged to a video game developer.

5) Assuring that Unearned Royalties (Asset) are not offset by Royalties Payable (Liability) as this will artificially decrease liabilities of the company, as shown in the table below:

Balance Sheet

Correct

Incorrect

Assets: Unearned Royalties

$5,000

$0

Liabilities: Royalties Payable

$15,000

$10,000

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