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written by | May 13, 2022

What Is Royalty in Accounting? Types & Working Criteria

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The term "royalty" refers to the amount due to use the benefits of certain rights granted to other individuals. For example, a landowner has rights over the mine on his property, and the book's writer is entitled to rights over the book.

If the rights are sold, the owner gets paid for this, known as royalty. Royalty is a recurring amount that depends on the amount of output paid in the name of the lender in exchange for the use of the lessee's rights. 

The person making payments to the owner is referred to as the lessee, while that person who is the proprietor of the asset is referred to as the lessor. Royalty is an expense of a business paid out and transferred to a profit or loss account.

Did You Know?

The royalties can cover kinds of property, including patents on inventions, use of artwork or the extraction of resources.

What is Royalties Accounting Meaning?

Let’s start with understanding royalty's meaning in accounts. The idea of "royalty" originated out of the Latin language, in which "regalis" was a reference to "royal". The term is now used to refer to nothing associated with monarchy, but it directly refers to finances and money, generating a profit. 

Royalty is a financial reward for using patents, trademarks, copyrights, brands, franchises, natural resources and other forms of property. Be aware that it is not an offer to purchase an intellectual brand or property but rather a cost for its use. In simple terms, it is a normal cost for delivering services or trademarks.

It is used across a wide range of industries, including: for rent payments, using someone else's trademark or brand and paying the cost of using someone else's property. It is also possible to use the term royalty as a reference to rent to extract natural resources paid by the owner of the land or subsoil.

Also Read: What are the Types of Franchises Available in India?

How Do Royalties Function?

We can determine the number of royalties and payments in many ways. In the case of a franchise, scenario fees may be a definite per cent or variable in sales. In many instances, it is mandatory to pay a fee. The most common types of royalties are:

  • The number of units sold can determine the royalties paid to specific items (like the patent product, book, concert or musical composition). 
  • We can determine royalties for gas, oil and mineral properties by revenues or units, like tonnes of coal. 

In this instance, the royalty percentage may be low since sales are not high. As growth in sales increases, the royalty percentage could increase to the maximum.

Different Types of Royalty Accounts

The following are some types of royalties:

  • Copyright: Copyright gives legal rights to the writer (of his book) or photographers (on his images), or any other type of intellectual work. Copyright royalty is paid from the publisher (lessee) of a book to the writer (lessor) of the book or the photographer per the publisher's sale.
  • Mining Royalty: The lessor of a quarry or mine is liable for a royalty payment to the lessors of the mine and quarry. It usually depends on the output.
  • Patent Royalty: The lessee will pay out the royalty for patents by the lessor according to the production or output of the particular product.

Party in Royalties Accounting

(i) Lessor: The individual who owns or creates the asset and gives the right to use an asset to a third party is the lessor or landlord. Additionally, the lessor gets payment for using his asset from the third-party making use of his property.

Examples of lessees are the author of a work, mining owner or quarry, or artist when it comes to a musical composition, etc.

(ii) Lessee: A Lessee is an individual who uses the assets of the creator or owner as a payment for the use of such an asset. Examples of Lessees include miners, publishers, etc.

Important Terms in Royalties Accounting

After knowing about the royalty definition in accounting, let’s examine why it is so important?

Minimum Rent

In addition, the lessor makes an agreement or a contract with the lessee regarding royalties due. The amount of royalty is calculated according to the number of products produced or the quantity of the goods sold. There are instances where the quantity of products sold or produced is very low or even zero. The lessor would get only a small or no royalty in this scenario, directly impacting the lessor's income.

Also, if there aren't any or minimal sales or production, the lessor will be in a position of loss, and the lessee will pay the least amount of royalty. This is even though the lessee uses the asset. To avoid this kind of scenario, the lessee must pay an amount minimum, regardless of the amount of merchandise the lessor made or offered.

The lessee must pay an amount that is minimum to the lender. This is even though the actual amount of royalty is calculated using the goods sold or produced. It doesn't include the amount of rent that you must pay. This type of guaranteed minimum, which the lessee receives, is known as the minimum rental. Minimum rent is determined at the point when the lessor signs an arrangement with the lessee.

It is a clause in the lease contract in the landlord's interests because it guarantees minimum rent, even in case of lower output or sales. The lessee, therefore, needs to pay the minimum amount of rent/fee or more amount of royalty. The Minimum due amount of rent always remains definite. It's also referred to by the name Fixed Rent, also known as Dead Rent. However, this can vary as per the terms of the contract. 

Example:

Let's say a mine generates output A of 4,000 tonnes. 

The royalty payable by the lessee is ₹100 per ton. The minimum rent in the contract is ₹5 Lakhs.

According to production, the real royalty amount due is ₹4 Lakhs. Because the actual amount of royalty is lower than the rent minimum, the lessee must pay at least ₹5 Lakhs to the lessor.

Short Workings or Dead Rent That Is Redeemable

Short Workings refers to the amount at which that minimum rental is greater than actual royalties. Also, short working refers to the difference between the minimum rent and the actual royalty. It is important to note that Short Workings comes into the picture only when the clause for minimum rent is in the contract.

Excessive Work

Excess working is nothing but the amount at which Actual Royalty is more than the rent minimum. For instance, in the previous example, the factory's output is 6000 tonnes. This means that the extra work is at ₹2 lakhs (₹6 lakh - ₹4 lakh).

Also Read: How to Check if Trademark is Available?

Recoupment of Short Workings

Usually, the agreement signed by the lessee and the lessor under Royalty Accounting provides for a clause. This allows them to carry forward short work to be adjusted to them in the future.

Thus, in the subsequent years, the amount of Short Workings adjusts against the amount of royalty. This method of adjusting the capital for Short Workings is what we call Recoupment of Short Workings.

In this way, the clause on the recoupment clause in the Royalty Agreement. It provides the right for the lessee to collect the excess money he paid to the lessee for the failure to comply with the requirement of minimum rent for the preceding years.

In addition, a time frame is set in the agreement. The period is when the lessee has to pay back short Workings. The time frame can be either definite or fluctuating.

Conclusion

The essence of royalties is an opportunity for creators, innovators, intellectual property owners or landowners to earn money through their property. They are agreements or licences that spell out the conditions under which a third party can use assets that belong to another. 

If you have any questions, post your comment below. Also another tip is to keep calculations of your debit and credit reports to know the exact profit and loss calculations. This is highly important in a business to grow and make further strategies. 

Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

FAQs

Q: What are various types of royalty accounts?

Ans:

The following are some types of royalties:

  • Copyright
  • Mining Royalty
  • Patent Royalty

Q: What is the minimum amount of rent for royalty?

Ans:

It is the lessee's amount for an asset from the owner so that the lessor gets a minimum amount for a certain time. And the situation where he earns an advantage or not is what we call the minimum rent.

Q: How do you track royalties in your accounting?

Ans:

The amount paid by the lessee concerning royalties is a normal business expense and will be debited from the Royalty account. It's a non-debit account, and at the close of the financial year, the balance of the Royalty account has to move to the regular Trading and Profit & Loss account.

Q: Royalty account is which type of account?

Ans:

It's a nominal account.

Q: Are royalty expenses a direct cost?

Ans:

Royalty is similar to a rental that you pay in order to use certain rights. Also, royalty relies on production and sales. If someone pays based on production, it's a direct expense.

Q: What is royalty in accounting?

Ans:

It isn't tough to understand royalty's meaning in accounts. Royalty is fundamentally an opportunity for creators, intellectual property owners, innovators, or landowners, to earn income through their property. Royalties are typically in the form of agreements or licences that spell out the terms under which a third party can use assets that belong to another.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.