Royalty Account: Royalty Meaning in Accounting
Royalty Account: Royalty Meaning in Accounting
Royalty is a consideration received by business entities or individuals who sell their creations to a
third party for use. Typically, royalty is considered to be synonymous with rent, however, its
concept and application vary completely.
Although, the user of asset pays consideration to the owner for using the owner’s asset both in the
case of acquiring a property on rent or a book for publishing. However, royalty is different from
the rent paid by the user.
Where rent is paid for using tangible assets like building, machinery etc, royalty is paid for using
intangible assets or availing special rights such as patents, copyright, mines etc.
Furthermore, the amount of rent paid by the user is fixed. Whereas royalty paid by the user to the
owner varies based on the number of goods produced or sold.
Thus, such a payment made by the user to the owner is known as Royalty. Furthermore, the
consideration paid instead of using the asset of the owner is determined in terms of the number of
items produced or sold.
• Lessor
The person who creates or owns the asset and provides the right to use such an asset to the third
party is known as the lessor or the landlord. Furthermore, lessor receives consideration from the
third party for using the rights to use his asset. Examples of lessors include the owner of the mine
or quarry, author of a book, artist in case of a music composition etc.
• Lessee
Lessee is the person who uses the asset of the creator or the owner in lieu of consideration for
using such an asset. Examples of Lessees include publishers, miners etc.
• Copyrights
Copyright provides the right to the author or owner of assets like book, artwork, music composition
etc. to claim royalty from the publisher. Therefore, publishers pay copyright royalty to the author
based on sales made by the publishers.
• Patent Royalty
Patent Royalty is paid by the user to the owner based on the number of items produced.
• Mining Royalty
In the case of Mining Royalty, the user or the lessee pays a royalty to the owner or the lessor based
on the output produced.
Therefore, in the case of a patent or a copyright, the publisher pays a royalty to the author based
on the number of book copies sold. In other words, the holder of the patent or copyright receives
a royalty based on the number of items sold by the user. Whereas, in the case of mining, the royalty
is received by the owner of the mine based on the number of items produced by the user.
• Minimum Rent
As mentioned above, the lessor enters into contact or an agreement with the lessee for the payment
of royalty. This royalty is determined based on the number of goods produced or the quantum of
goods sold.
Now, there can be cases when the number of goods produced or sold is nill or relatively low. In
such a case, the lessor would receive no or little royalty directly impacting lessor’s royalty income.
In other words, when there is no or little production or sale, the lessor would be at a loss since no
or less amount of royalty would be received from the lessee. This is despite lessee using the asset.
To get rid of such a situation, the lessor requires a minimum amount of payment to be paid by the
lessee irrespective of the number of goods produced or sold by the lessee.
That is, the lessee is required to pay a minimum amount to the lessor. This is even though the
actual royalty amount, which is calculated based on the items produced or sold, is less than the
minimum rent to be paid.
Such a guaranteed minimum amount so received by the lessor is called the minimum rent.
Minimum rent is fixed at the time when the lessor enters into an agreement with the lessee.
It is a term included in the contract in the interest of the landlord as it assures minimum rent even
in cases of lower sales or output. Therefore, the lessee pays minimum rent or the actual royalty
amount, whichever is higher.
Since the amount of minimum rent to be paid is fixed, it is also known as Fixed Rent or Dead Rent.
This can, however, vary depending upon the terms of the agreement.
For example, say the output produced by Mine A is 4,000 tons. The royalty to be paid by the lessee
is Rs 100 per ton and the minimum rent in the agreement is Rs 5 Lakhs.
As per production, the actual royalty amount to be paid comes at Rs 4 Lakhs. Since the actual
royalty amount is less than the minimum rent, the lessee is required to pay a minimum rent of Rs
5 Lakhs to the Lessor.
In the example above, the Short Workings amount to Rs 1 Lakh (5 Lakh – 4 Lakh). It must be
noted that Short Workings comes into picture only when the clause of minimum rent is included
in the agreement.
• Excess Working
Excess Working is nothing but the amount by which Actual Royalty is more than the minimum
rent.
Say for instance, in the example above, the output produced is 6000 tons. Accordingly, excess
working comes out to be Rs 2 Lakhs (6 Lakh – 4 Lakh).
Therefore, in the following years, Short Workings is adjusted against the excess royalty amount.
Such a process of adjusting Short Working capital is known as recoupment of Short Workings.
In other words, the clause of recoupment in Royalty Agreement provides the right to the lessee to
recover the excess payment made by him to the lessor for complying with the clause of minimum
rent in the previous years.
Furthermore, a time period is stipulated in the agreement. Such a period lays down the number of
years during which Short Workings can be recouped or recovered by the lessee. This time period
can be fixed or fluctuating.
In cases where the lessee fails to recover the Short Workings within the stipulated time, the Short
Working's lapse and is debited to the P&L Account for the period in which the recoupment lapses.
• Fixed Right
Fixed Right means that the lessee can recover short working from the lessor within a particular
time period from the date of the lease of the asset.
For instance, as per fixed right, say the lessee can recover Short Workings within 2 years from the
date of the lease. In case he fails to do so, the recoupment lapses or ends.
• Fluctuating Right
Under Fluctuating Right, the lessee can recover Short Workings for any period during the
subsequent period or periods. For instance, Short Workings of the previous year can be recovered
in the subsequent year.
As per the terms of the agreement, Short Workings can be recovered in the year in which actual
royalty exceeds minimum rent. In case, lessee fails to recover Short Working in a specific period,
it becomes irrevocable and is charged to P&L in the year in which the Short Working recoup
lapses.
On the other hand, Short Working that can be recovered must be carried forward and shown as a
current asset in the balance sheet.
(Being cash received from Kapoor Ltd and Short Working Recouped)
3. Closing Entry at the Year-End and Short Working Unrecouped