Royalty Explained: What It Is, Its Types, and How to Account for It

Royalty Accounts

Royalty refers to the payment made for the right to use an asset or property owned by another party. The amount paid for this privilege is known as the royalty fee.

In other words, royalty is the remuneration paid to a person or entity for the use of an asset whether leased or purchased calculated based on the quantity of goods produced or sold as a result of using that asset. Common examples include royalties paid for the use of natural resources such as mines or oil wells.

The term "royalty" typically implies a payment made by a lessee or tenant (the user) to the lessor or landlord (the owner) for the use of certain rights or assets belonging to the latter. It is essentially compensation for the privilege of using intellectual or physical property.

Examples of Royalty Payments Include:

• The right to extract minerals (e.g., coal, iron, oil)
• The right to publish and sell an author’s book
• The right to use a patented invention or process

Royalty arrangements are common in industries such as publishing, mining, music, film, and technology, where the use of someone else’s property or intellectual rights generates revenue.

Royalty Accounts

According to J.R. Batliboi, “The term royalty expresses an amount payable by one person in return for some special right or privilege conceded to him by another person, such as the right to publish a book, to manufacture and sell a patented article, or to work a mine.”

A Royalty Account is a nominal account. It represents an expense for the lessee (the person who pays the royalty), and income for the lessor (the person who receives it). Accordingly:

• For the lessee, royalty is debited as an expense.
• For the lessor, royalty is credited as income in the Lessor's Account.

Classification of Royalty Based on Nature

• When royalty is based on output (e.g., quantity produced or extracted): It is considered a manufacturing expense and is transferred to the Production Account or Trading Account.
• When royalty is based on sales: It is treated as a selling expense and is transferred to the Profit and Loss Account.

Examples of Royalties

• Royalty for extracting minerals (e.g., coal, iron ore)
• Royalty for publishing a book
• Royalty for using a patent or manufacturing process

These payments are made under a legal agreement and typically vary with the volume of production or sales, making royalty accounting an important aspect of financial reporting in businesses where such agreements are common.

Characteristics of Royalty

1. Purpose - Royalty is paid for a specific, predetermined purpose, typically involving the use of a right, asset, or intellectual property.
2. Duration - Payments are made at regular intervals, usually on an annual or semi-annual basis.
3. Consideration - Royalty serves as consideration (payment) for the use of a right or privilege, such as a patent, copyright, or natural resource.
4. Agreement - A formal agreement is established between the payer and the receiver of the royalty. This agreement outlines key terms such as the royalty rate, payment schedule, and conditions like minimum rent or guaranteed payment.
5. Use - The right or privilege is typically used for production, utilization, or extraction purposes—for example, mining coal, using patented technology, or publishing books.
6. Rate of Royalty - A fixed rate is set for calculating the royalty, usually based on measurable units such as per ton, per book, or per unit produced or sold.

Types of Royalties

Royalty payments can take various forms depending on the nature of the asset or right being used. The main types include:

1. Mining Royalties - Paid for the extraction of minerals such as coal, iron ore, limestone, and other natural resources from mines.
2. Brick-Making Royalties - Paid for the use of land or raw materials for the manufacturing of bricks.
3. Oil Well Royalties - Paid for extracting crude oil or natural gas from oil wells.
4. Patent Royalties - Paid for the use of a patented invention, design, or process owned by another party.
5. Royalties for Machinery, Secret Processes, and Technical Know-How - Paid for the use of proprietary machinery, confidential manufacturing methods, or specialized technical expertise.
6. Royalties on Sale of Production - Calculated based on the quantity or value of goods produced or sold using someone else's intellectual property or resources.
7. Trademark Royalties - Paid for the use of a registered trademark, brand name, or logo owned by another entity.
8. Other Royalties - This category includes any royalty payments not specifically covered above, such as royalties for copyrighted content, franchise rights, or licensing of creative works.

Difference Between Royalty and Rent

Basis	Rent	Royalty
1. Definition	Rent is the payment made for the use of tangible assets such as land, buildings, or machinery.	Royalty is the payment made to the owner for the use of a special right, often related to intangible assets or natural resources (e.g., patents, trademarks, minerals).
2. Basis of Payment	Rent is typically paid based on time—such as per year, month, week, or day.	Royalty is generally paid based on output, production, or sales—such as per ton, per unit, or per article sold.
3. Variability	Rent is usually a fixed amount agreed upon in advance.	Royalty amounts vary depending on the level of production or sales. It is not fixed.

Explanation of Technical Terms Used in Royalty

Royalty

Royalty is a payment made by the lessee (user) to the lessor (owner) for the use of a special right or property. It is usually calculated based on production or sales.

Formula: Royalty = Production × Rate per unit

Minimum Rent (Dead Rent / Fixed Rent / Contract Rent)

Minimum Rent is the assured minimum amount that the landlord (lessor) receives, regardless of the actual production or sales. If the calculated royalty is less than the minimum rent, the lessee still must pay the minimum rent.

This clause ensures the owner doesn't incur a loss in low-production periods.

Short Working

When actual royalty is less than the minimum rent, the difference (extra amount paid by the lessee) is called Short Working. This is essentially a prepayment that may be recoverable in the future when royalties exceed the minimum rent.

Formula: Short Working = Minimum Rent – Actual Royalty

Causes of Short Working:

• Low production
• Lower sales than expected
• Temporary business disruptions

Surplus

Surplus occurs when the royalty earned in a particular period exceeds the minimum rent. This excess amount can be used to recoup previous short workings (if allowed under the agreement and within the recoupment period).

Formula: Surplus = Actual Royalty – Minimum Rent

Unrecouped Short Working

If short workings are not recouped within the agreed-upon time (as per the contract), they become unrecouped. This unrecovered amount is written off as an expense and transferred to the Profit and Loss Account in the lessee's books.

Lessor (Landlord)

The lessor is the owner of the asset or rights who grants the use of the property and receives royalty payments in return.

Lessee

The lessee is the person or entity using the asset and making royalty payments to the lessor in exchange for the rights granted.

Understanding Minimum Rent and Short Working with Example

1. In the initial years, production may be low, resulting in royalty being lower than the minimum rent. In such cases, the lessee pays the minimum rent, and the difference is recorded as short working.
2. In later years, when production increases, royalty may exceed the minimum rent. The excess (surplus) can then be used to recoup previous short workings, as per the terms of the agreement.

Recoupment of Short Working

To protect the lessee from loss due to underutilization in the early years, royalty agreements often include a recoupment clause. This allows the lessee to adjust short workings from future surpluses (i.e., when actual royalty exceeds minimum rent).

Conditions for Recoupment (usually):

• Must occur within a specified period (e.g., 2 to 3 years from the year of short working).
• Can only be recouped from surplus royalty, not from minimum rent payments.

Accounting Procedure for Royalty

Before preparing the Royalty Accounts, the following key details must be noted:

1. Name of the Landlord and Lessee – Identifies the parties involved in the agreement.
2. Period of Lease – Duration for which the rights are granted.
3. Commencement of Agreement – The date the lease or royalty agreement becomes effective.
4. Royalty Rates – The rate at which royalty is calculated (e.g., per ton, per unit, per book).
5. Minimum Rent – The minimum guaranteed payment to the landlord, irrespective of output or sales.
6. Right of Recoupment of Short Working – Whether the lessee can recoup short workings and the time period allowed for such recoupment.
7. Mode of Payment to Landlord – Payment terms (e.g., bank transfer, cheque, etc.).

Preparation for Journal Entries

Before passing journal entries, it is useful to create a calculation table to simplify and organize the data. Below is the format:

Year	Output	Royalty (Rs.)	Short Working (Rs.)	Short Working Recouped (Rs.)	Unrecouped Short Working (Rs.)	Amount Paid to Landlord (Rs.)

This table helps determine:

• The royalty due
• Whether short working exists
• Whether it can be recouped
• The actual payment made to the landlord

Accounts to Be Opened in the Books of the Lessee

1. Royalty Account - Records the amount of royalty expense incurred based on actual production or sales.
2. Landlord’s Account - A personal account showing amounts due and paid to the landlord.
3. Short Working Account - Used to record and track the short workings. Also helps in recoupment and in determining unrecouped amounts to be transferred to the Profit and Loss Account.

Journal Entries Under Different Circumstances

1. When royalty < minimum rent
2. When royalty > minimum rent
3. When royalty = minimum rent

Case 1 – When royalty is less than minimum rent, the following entries will be made:

Suppose the amount of royalty is 30,000 while the amount of minimum rent is 35,000

When royalty is payable 

Royalty account                                                         Dr.	30,000
Short working account                                               Dr.	5,000
To Landlord account		35,000
(For amount of royalty and short working due)

When payment is made

Landlord  account                                                      Dr.	35,000
To Cash or Bank account		35,000
(For minimum rent paid to landlord)

For closing of royalty account at the end of year

Profit and loss  account                                             Dr.	30,000
To Royalty account		30,000
(For royalty account closed by transferring to P&L account)

Case 2 – When the royalty is more than minimum rent, the following entries will be made

Suppose the amount of royalty is 40,000 while the amount of minimum rent is 30,000.

When royalty is payable 

Royalty account                                                         Dr.	40,000
To Landlord account		40,000
(For amount of royalty is due to landlord)

When payment made and short working recouped

landlord account                                                         Dr.	40,000
To Cash account		30,000
To Short working account		10,000
(For royalty payment done and short working recouped)

For closing of royalty account at the end of year

Profit and loss account                                                Dr.	40,000
To Royalty account		40,000
(For royalty account closed by transferring to P&L account)

For closing of irrecoupable short workings 

Profit and loss account                                              Dr.	10,000
To Short working account		10,000
(For short working account transferred to P&L account)

Case 3 When the royalty is equal to minimum rent the following entries will be made

 Suppose of royalty is 35,000 while the minimum rent is also 35,000

When royalty is payable

Royalty account                                                       Dr.	35,000
To Landlord account		35,000
(For royalty account is due to landlord)

When payment is payable

Landlord  account                                                     Dr.	35,000
To Cash or Bank account		35,000
(For royalty paid to landlord)

For closing of royalty account at the end of year

    

Profit and loss account                                                  Dr.	35,000
To Royalty account		35,000
(For royalty account closed by transferring to P&L account)

FAQ’s

What are the common types of royalty?

Common types include copyright royalty, patent royalty, natural resource royalty, franchise royalty, and trademark royalty.

What is minimum rent in a royalty agreement?

Minimum rent is the guaranteed minimum amount that the lessee must pay the lessor each year, regardless of the actual production or sales.

How is royalty usually calculated?

Royalty is typically calculated based on production output, sales volume, or usage, using a fixed rate per unit (e.g., per ton, per book).

What is a royalty agreement?

It’s a contract between the owner (lessor) and user (lessee) outlining the terms of royalty payment, minimum rent, recoupment rights, and other condition.

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