The concept of “royalty” came from the Latin language, where “regalis” meant “royal”. Today, the term has nothing to do with monarchs, but it directly relates to finances, money, making a profit. Royalty is a type of monetary reward for the use of copyrights, patents, trademarks and brands, franchises, natural resources, and other types of property. Note that royalty is not a payment for the purchase of intellectual property or a brand, but a fee for its use. In simple words, royalty is a regular fee for the provision of services or a trademark.
People use this term in many industries, for example: when paying rent, when using someone else’s brand or trademark, when paying for the use of other’s property. People can also use royalty as a term meaning rent for the right to mine natural resources, which the entrepreneur pays to the owner of the land or subsoil.
The parties to the license agreement are the licensor and the licensee:
- Licensor – one who provides the other party (licensee) the right to use intellectual property, etc.;
- Licensee – pays for and accepts the use of an intellectual property.
Royalty Payment Accounting Example
Companies that use or provide for use any intellectual property, for example, patents, computer programs, or trademarks, come across the royalties. Under the terms of the agreement, the company would make payments to the owner for the use of this intellectual property.
Although specialists always recommend using the services of professional accountants to reduce the likelihood of making a mistake in the financial statements, let’s figure out how to reflect these royalty payments in accounting records correctly.
For example, a book author gives his book to the publisher and accepts royalty payments in return. The publisher will print the book and sell it to the public. He will make royalty payments to the author in two stages:
- An advance royalty payment of $20,000 when they sign the agreement;
- A regular payment equal to 10% of the net income of $10,000 paid annually.
Advance on Royalties
A $20,000 advance royalty payment to the book author (licensor) is required according to the agreement so that the book publisher will record it as a prepayment. The author will receive an advance payment equal to $20,000, and the publisher (licensee) would need to make the following record in the accounting books:
Regular Royalty Payments
So, the author publishing the book received an advance payment equal to $20,000 and is entitled to 10% of revenue from sales. Thus, he can count on income only after sales exceed $200,000 because he already received an advance royalty payment for this sales amount in the beginning.
So, if by the end of the accounting period the publishers sell books for $150,000, he will make the following journal entry to reflect royalty payment to the licensee (calculated by multiplying net income of $150,000 by 10%, which is $15,000).
By the end of the next year, the book publisher sells books only for $100,000. Such action means that he will pay royalties equal to $10,000. Since the publisher will exhaust royalties prepayments after spending $5,000, the remaining $5,000 he will pay in cash. The publisher will record the royalty payments as follows:
Stepped Royalty Payments
The book author can also enter into an agreement where the publisher would pay a higher royalty fee after a set amount of books sold, let’s say 10,000 books. Here we see a stepped royalty agreement, and the book publisher would need to record these payments slightly different. The parties should note that it can often be challenging to predict future sales correctly.
The author receives $3 per book for the first 10,000 books and then gets $5 for all sales after that. So, if the publisher sells 15,000 books during the reporting period, this would mean that the author will earn $55,000 ($3 x 10,000 + $5 x 5,000). Assuming the publisher will make the payment at the end of the period, he will record it as follows:
Royalty Income Accounting Example
We just reviewed how the publisher (licensee) would record the royalty fee payments. The author (licensor) is likely to keep a record of these same payments as well. How will the licensor’s papers look like provided that we use the same information as in examples above? Let’s take a look.
Advance on Royalty Income
The author receives the royalty advance of $20,000 from the book publisher. He will use the Unearned Royalty account under Current Liabilities because the book publisher did not sell the books, and the author has yet to earn this money.
Regular Royalty Income
By the end of a reporting year, the book publisher sells books for $150,000, and the author earns $15,000 in royalty fees. Thus, the advance royalty payment is now earned. The author has to make a record of the royalty revenue earned this far.
During the next reporting period, the author will earn $10,000 more in royalty fees. Since he did not earn only $5,000 of the royalty advance payment, the other $5,000 will be the revenue he will receive from the publisher for this reporting period. The journal entry will look as follows:
The Unearned Royalties account will now have a balance of $0.