The owner of a long term asset such as for example a patent or copyright can issue a licence to another party allowing then to use the asset in return for payments referred to as royalties. The owner of the asset who issues the licence and receives the royalty is known as the licensor. The person who makes use of the asset and pays the royalty is known as the licensee.
Royalties can take many different forms and the calculations can be complex however, fundamentally they depend on the amount to which the asset is used by the licensee. For example, a publisher might pay a royalty to an author for each copy of their book sold, or a manufacturer might pay a royalty to an inventor based on the revenue earned from the sale of their product.
Royalty Payment Accounting Example – Licensee
The developer (licensor) of a video game grants a licence to a publisher (licensee) in return for royalty payments. The publisher agrees to produce, market and distribute the game to end users.
The royalty payments to the developer are to be made in two stages.
- An advance royalty payment of 5,000 when the agreement is signed.
- A regular payment of 8.00 for each game sold.
Advance on Royalties
The advance royalty payment of 5,000 is paid on the signing of the royalty agreement and is classified as a prepayment in the accounting records of the publisher (licensee).
The following bookkeeping journal is used to record the royalty advance.
|Advance on royalties||5,000|
The developer in effect receives upfront payment of future royalties.
Since the developer earns 8.00 for each game sold, the 5,000 represents a prepayment of 625 (5,000/8) sales. From the publishers point of view this is a prepayment and is included as a balance sheet current asset until the royalty is earned by the developer when the game is sold.
Regular Royalty Payments
Suppose at the end of the first accounting period 500 video games have been sold. The royalty due to the developer is 4,000 (500 x 8.00), and the publisher posts the following journal entry to record the payment.
|Advance on royalties||4,000|
The developer has now earned royalties of 4,000 and the publisher transfers this from the prepayment account (advance on royalties) to the royalty expense account. The balance on the advance on royalties account is now 1,000.
During period 2 a further 600 games are sold and the royalty due to the developer (licensor) is 4,800 (600 x 8.00). The publisher (licensee) now posts the following bookkeeping entry.
|Advance on royalties||1,000|
The royalty expense for the period is 4,800, since the balance on the advance payments account is 1,000, the developer is owed a further 3,800. If the amount is paid after the period end (which it is in this example), it is shown as a balance sheet current liability account under the heading royalties payable. The balance on the advance payments account is now zero.
Stepped Royalty Payments
Stepped royalties are simply a method of calculating the royalty due. A stepped royalty arrangement changes the royalty rate at different levels of sales.
In the above example the royalty due was 8.00 for each video game sold. Under a stepped royalty arrangement the rate might have been 8.00 for the first 1,000 games sold and 9.00 thereafter. In this case the royalty due would have been calculated as follows.
Period 1: Sales = 500 Royalty = 500 x 8.00 = 4,000 Period 2: Sales = 600 Royalty = 500 x 8.00 + 100 x 9.00 = 4,900
The total sales are 1,100, during period 2 the sales reach the 1,000 step and the royalty rate is increased to 9.00 per sale for the final 100 units sold during the accounting period.
Royalty Income Accounting Example – Licensor
The licensor receives royalty income from the licensee. In the above example, the developer was the licensor and received a royalty at the agreed rate from the publisher (the licensee).
Using the same information from the example above, the developer would make the following bookkeeping entries to record the transactions.
Advance on Royalties Income
The developer receives the royalty advance of 5,000 from the publisher
Since the royalty has not yet been earned, the advance is recorded in a balance sheet (unearned royalties) account representing a current liability to the publisher until the game has been sold in sufficient quantities to earn the royalty.
Regular Royalties Income
In period 1, 500 copies of the game are sold and the developer earns 4,000 in royalties and makes the following posting.
The developer has earned 4,000 and makes the entry to transfer this amount from unearned royalties in the balance sheet to the royalty revenue account in the income statement.
In period 2 a further 600 games are sold and the developer makes the following entry.
The royalty revenue for the period is 4,800, since the balance on the unearned royalty account is 1,000, the developer is owed a further 3,800. If the amount is paid after the period end (which it is in this example), it is shown as a balance sheet current asset account under the heading royalties receivable. The balance on the unearned royalty account is now zero.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.