Royalty accounts

Royalty Accounts maintain by publisher of book. Publisher need to pay writer which is called royalty.

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Royalty Accounts


Some business which the owner has a right or monopoly towards some goods or
services can allow other firms to exercise the right. The owner will get a gratuity
based on how far the rights have been exercised.
In other words, it is a transaction whereby an owner gives a right to other company
or user to use his/her own properties, and in return, the user will then give a
compensation or payment which is known as royalty.
According to MASB (Malaysian Accounting Standard Board), royalty is the
remuneration payable to a person in respect of the use of long term assets such as
patent, trademarks, copyrights and computer software.

The main forms of royalty

a) Mining royalty – to extract mineral and ore from earth

b) The book publisher gives gratuity to the author / writer

c) For the use of a design

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Royalty Agreement

A royalty agreement will normally contain clauses dealing with the following:

a) Minimum rent – guaranteed amount which the landlord, inventor or author is to
receive whatever the output maybe.
b) Royalty per unit per output
c) Right to recoup short-workings
d) Right to subject part or whole of tenancy agreement

Minimum Royalty and Short Workings
The payment of royalty is based on the unit of output produced. However, if the sum
of royalty is less than the minimum rent (if any), then the payment will be based on
the minimum rent (minimum royalty – minimum rent).
The difference between the royalty and the minimum rent is known as ‘Short
Working’. Normally, the tenant may obtain the right to recover the short-workings.

Example 1: Royalty without any minimum rent
A landlord granted a lease to mining company whereby he is to receive RM0.05 per
ton of ore mined.
The output for the first 3 years is:

1st year 10,000 tons
2nd year 20,000 tons
3rd year 24,000 tons

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Solution:
The landlord will receive the royalty of:
1st year RM 500 (10,000 x RM0.05)
2nd year RM1,000 (20,000 x RM0.05)
3rd year RM1,200 (24,000 x RM0.05)
RM2,700

Example 2 : With a minimum rent – also with the rights to recoup short-workings
A landlord granted a lease to mining company whereby he is to receive RM0.05 per
ton of ore mined.
The output for the first 3 years is:
1st year 10,000 tons
2nd year 20,000 tons
3rd year 24,000 tons
Assume that the minimum rent is RM800.
Solution:

Year
Calculation of
Royalty
Minimum
rent
Payment
Short workings
Current Written
off
Recoverable
1
10,000xRM0.05
= RM500
800 800 300 - -
2
20,000xRM0.05
= RM1,000
800 800 - - 200
3
24,000xRM0.05
= RM1,200
800 1,100 - - 100

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Minimum Rent:

Usually, the royalty agreements contain a clause for the payment of a fixed minimum
amount to the lessor every year as royalty—irrespective of the actual benefit to be
taken by the lessee—simply in order to assure the lessor of a certain regular income
from his property.
This minimum amount is known as “Minimum Rent, ‘Dead Rent’, etc. It is to be
remembered that the Minimum Rent may or may not vary in different years. The
Minimum Rent or actual royalty, whichever is higher, is to be paid to the lessor. For
example, X leased a mine from Y at a Minimum Rent of Rs. 12,000 p.a. merging a
royalty of Rs. 2 per ton of coal raised.
Now, if the quantity raised for the 1st year amounted to 4,000 tons and that of 2nd
year 8,000 tons, in that case, X will have to pay Rs. 12,000 for the 1st year to Y, i.e.,
the Minimum Rent [since actual royalty (8,000 = 4,000 × 2) is less than Minimum
Rent]. On the contrary, he will have to pay Rs. 16,000 to Y for the 2nd year [since
actual royalty (16,000 = 8,000 × 2) is more than the Minimum Rent.].

Short-working:

The excess of Minimum Rent over actual royalty is known as short-working.
Therefore, question of short-working will only arise when the actual royalty is less
than the Minimum Rent. Short-workings which are recoupable will appear in the
assets side of the Balance Sheet as a current asset.
In the above example, short-working for the 1st year will be Rs. 4,000 [i.e., Rs.
12,000 – Rs. 8,000 (4,000 × Rs. 2)], since actual royalty is less than the Minimum
Rent. But, in the 2nd year, there will be no such short-working since actual royalty
is more than the Minimum Rent.

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Recoupment of Short-working:
Usually, in a royalty agreement, a further provision is included about the recoupment
of short-working, i.e., the lessor allows the lessee the right to carry forward and set
off the short-working against the excess or surplus of royalties over the Minimum
Rent in the subsequent years.
In other words, the lessor promises to adjust or return the excess which was charged
in the first few years out of excess earned in the later or subsequent years. This right
is known as the right of recoupment of short-working.
It can be presented in the following manner:
(a) Fixed;
(b) Floating.
(a) Fixed:
If the lessor or landlord agrees to compensate the losses which were incurred in the
first few years (say, three or four years) the same is known as fixed, i.e., if any short-
working falls beyond this period, the same cannot be reimbursed.
(b) Floating:
If the lessor or landlord agrees to compensate the loss which were incurred in the
first few years, in the next or following or subsequent three or four years, the same
is known as floating as the same can be adjusted in any year if short-working arises,
i.e., each year’s short-working will have to be adjusted against the excess royalties
earned in the subsequent years accordingly.
Students must remember in this respect that the short-workings which are not
recovered within the stipulated period should be treated as irrecoverable, and, hence,
should be transferred to Profit and Loss Account of the year in which the same is
lapsed. The recoupable part of short-working is shown in the asset side of the
Balance Sheet. Provision to be made for Short-workings

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It has already been stated above that recoupable short-working appears in the assets
side of the Balance Sheet as a current asset on the assumption that the same will be
recouped in future. But it is uncertain. Sometimes, it may not be possible for the
lessee to recoup the amount of short-working due to many factors although he has
got the legal right to recoup.
From the standpoint of conservatism a provision should be made for such short-
workings against Profit and Loss Account in that particular year when such short-
working appears. It is needless to say that provisions for short-working will appear
in the liabilities side of the Balance Sheet.
Whereas short-workings (recoupable) will appear in the assets side of the Balance
Sheet. Consequently, un-recoupable part of the short-workings will be adjusted
against such provision and not against Profit and Loss Account. The balance of
provision, if any, should be credited to Profit and Loss Account.
Short-working and Minimum Rent—their relationship:
It has already been explained earlier that when the actual royalty (calculated on the
basis of a fixed rate to total quality) is less than the amount of the minimum fixed
amount (i.e., Minimum Rent) short-working arises. In short, short-workings arises
only when actual royalty is less than the Minimum Rent i.e.,
Short-working = Minimum Rent – Actual Royalty
or, Minimum Rent = Actual Royalty + Short-working
However, in the case of landlord, the amount of Minimum Rent is equal to Actual
Royalty Receivable plus the short-workings, i.e.,
Minimum Rent— Actual Royalty Receivable + Short-working
It must be remembered that the landlord is entitled to get the Minimum Rent or
Actual Royalties, whichever is higher, (after adjusting the amount of Short-
workings, if any.) Ground Rent — Sometimes the Lessee is to pay an additional
fixed rent in addition to the minimum rent which is known as Ground Rent or Surface
Rent.

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Method of Accounting:

A. Where there is a Clause on Minimum Rent and Recoupment of Short-
working consequently?

Books of Lessee or Tenants or Licence:
Entries

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Practically, royalties based on output should be debited to Manufacturing or
Production Account whereas royalty based on sales be treated as selling expenses)
should be debited to Trading Account on Profit and Loss Account.
Note:
It’s an advised to prepare the following chart before making actual attempt for
Solution:

To Sum up:
1. The landlord is entitled to have the Minimum Rent or Actual Royalty, whichever
is more (after adjusting the recoupment of short-working, if any).
2. If there is no clause in the Royalty agreement about the Minimum Rent, there will
neither be any short-working nor any recoupment.
3. The short-working which is recouped is to be shown as current asset in the asset
side of the Balance Sheet.
4. The recoupable part of short-working should be transferred to Profit and Loss
Account.
5. Royalty based on output should be debited to Manufacturing Account or
Production Account and royalty based on sales should be debited to Trading Account
or Profit and Loss Account.

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A reliable solution: Bengal Coal Ltd. got the lease of a colliery on the basis of 50
paise per ton of coal raised subject to a Minimum Rent of Rs. 20,000 p.a. The tenant
has the right to recoup short-workings during first four years of the lease and not
afterwards. The output in four years was 1st year-18,000 tons. 2nd year—26,000
tons. 3rd year—50,000 tons. 4th year—60,000 tons. 5th year—1, 00,000 tons. You
are required to give the Journal entries and ledger accounts in the books of the
company.

Interpretation:
1st year:
Actual royalty is less than the minimum rent by Rs. 11,000 (i.e., Rs. 20,000 – Rs.
9,000) which should be carried forward up to first four years if not recouped.
2nd year:
Again actual royalty is less than minimum rent by Rs. 7,000 (i.e., Rs. 20,000 – Rs.
13,000) which again carried forward. Thus, total amount of short-working which is
carried forward is Rs. 18,000 (i.e., Rs. 11,000 for first year and Rs. 7,000 for 2nd
year).
3rd year:
Since actual royalty is more than the minimum, rent by Rs. 5,000 (i.e., Rs. 25,000 –
Rs. 20,000) the same should be recouped against the short-working of Rs. 18,000.
Now, balance of short-working comes down to Rs. 13,000 (Rs. 18,000 – Rs. 5,000).

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4th year:
In this year also, actual royalty is more than the minimum rent by Rs. 10,000 (Rs.
30,000 – Rs. 20,000) which will be recouped against the balance of short-working
of Rs. 13,000. So, un-recoupable part of short-working, i.e.. Rs. 3,000 (Rs. 13,000 –
Rs.10, 000) should be transferred to P&L A/c as maximum period allowed for
recoupment of short-working was first four years.
5th year:
As there was no short-workings landlord will get Rs. $0,000 i.e., actual royalty or
minimum rent whichever is higher.

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When Minimum Rent Account is opened:
Entries in the books of Lessee/Licence/Users:

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This method is particularly applicable when Actual Royalty is less than Minimum
Rent.

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Illustration 2:
Accounts to be prepared in the books of Lessor:
M owned the patent of a folding chair. On 1st Jan. 2008, he granted N a license for
5 years to manufacture and sell the chair on the following terms:
(a) Royalty of Rs. 10 per chair sold,
(b) Minimum Rent of Rs. 15,000 p.a.
(c) Short-working could be recouped only within two years following the year in
which the short- working occurs, subject to a maximum of Rs. 3,500 p.a., and
(d) If in any year normal sale was not attained due to strike, the Minimum Rent was
to be regarded as having been reduced proportionately, having regard to the length
of the stoppage.
The number of chairs sold during the lease period was:

During 2011, there was a stoppage due to strike lasting 4 months.
You are required to show the entries and the ledger account of:
(i) Royalties Receivable,
(ii) Royalties Suspense, and
(iii) N’s account in the books of M for each of the above years.

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Interpretation:
2008:
Minimum Rent Rs. 15,000 and actual royalties were Rs. 9,000. So there was a short-
working of Rs. 6,000 (which was transferred to Royalty Suspense A/c)
2009:
Again there was a short-working of Rs. 2,000 (Rs. 15,000 – Rs. 13,000). So, total
amount of short-working amounted to Rs. 8,000 (Rs. 6,000 + Rs. 2,000) which was
carried forward.
2010:
This year is very important. In this year, there was an excess of Rs. 5,000 which
could be recouped. But, as per question, maximum amount of recoupment should be
Rs. 3,500. Hence, Rs. 2,500 (Rs. 6,000 – Rs. 3,500) should be credited to Profit and
Loss Account as the lease agreement provided that short-working could be recouped
only within two following years in which the short-working occurred.

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2011:
During strike period minimum rent would be reduced proportionately i.e., Rs. 15,000
x 8/12 = Rs. 10,000 (as 4 months were the stoppage period) so, royalties in excess
of minimum rent could be recouped i.e., Rs. 1,000 (Rs. 11,000 – Rs. 10,000) out of
the short-workings of Rs. 2,000 in 2009. As such balance of un-recoupable part i.e.,
Rs. 1,000 should be credited to P & L A/c.
For further details about strike, please see the subsequent paragraph.
2012:
Again, there was a short-working amounting to Rs. 1,000 which should be credited
to P & L A/c as the contract was made for 5 years i.e., there was no chance for
recoupment.

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B. Where there is no Minimum Rent?
Under the circumstances, there will not be any short-working; as such question of
recoupment of short-working also will not arise at all. Landlord is entitled to get the
actual royalties only.
The entries under this method are:

(1) Where Actual Royalty earned will discharge all rental obligations:
Under the circumstances, during the period of Strike or Lock-out, there will neither
be short-working nor will there be any recoupment. For example, the contract
stipulates that the Minimum Rent is Rs. 12,000 per year. But, during the period of
strike, actual royalty earned Rs. 8,000. Hence, landlord will get only Rs. 8,000. As
such, there will not be any short-working of Rs. 4,000 (Rs. 12,000 – Rs. 8,000) which
may be considered in other years.
(2) Where Minimum Rent is reduced proportionately:
Under the circumstances, the amount of Minimum rent will be reduced
proportionately having regard to the length of stoppage. For example, the Minimum
Rent is. 12,000 per year. Strike period is 3 months, as such, the amount of Minimum
Rent will be Rs. 9,000 (i.e., Rs. 12,000 × 9/12).
As such, if actual royalty earned is less than Rs. 9,000 there will be short-working
and, similarly, if actual royalties are more than Rs. 9,000, the excess portion may be
recouped (of course, if there is any short-working balance).

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Deduction of Income Tax:
We know that as per Income Tax Act, 1961, Income Tax must be deducted at the
prescribed rate by the lessee from the actual payment so made to the landlord and
deposited to the credit of the Central Government within the stipulated time.
Entries in the books of lessee will remain the same, i.e., the tax deducted at
source must not affect the royalty, except the following entries:
1. When payment is made to landlord:
Landlord A/c Dr. ―Minimum Rent
To Bank A/c ―Actual Payment
To Income Tax Payable A/c ―Amount of Income Tax deducted.
The following illustration will help us to understand the principles clearly:
Illustration 03:
Application of Income Tax:
Mr. Raman, a scientist, owned a patent for the manufacture of electric blanket. In
2006 he allowed Hindustan Manufacturing Ltd. the use of the patent on the terms
that he would receive a royalty of Rs. 10 per blanket manufactured subject to a
Minimum Rent of Rs. 12,000 in 2006, Rs. 16,000 in 2007, and thereafter Rs. 30,000
every year. Any short-workings is recoverable out of the royalties of the two years
subsequent to the year in which short-workings may arise.
The actual output is:
2006 —1000; 2007 – 1,200; 2008 — 3,200 and 2009 — 3,200. Income-tax was
deducted at source @ 20% every year before actual payment of royalty.

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You are required to show:
(i) Royalty Account;
(ii) Short-workings Account and
(iii) Mr. Raman Account from 2006 to 2009.

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