Financial Accounting Notes: Royalty Accounts Notes | Theory | MCQs | Online Test | Accounting Treatment

Royalty Accounts Notes 

For B. Com / BBA/ MBA/ CMA Exam

Introduction to Royalty Accounts:

Royalty is an amount payable for utilizing the benefit of certain rights vested with some other person. For example a landlord possesses right over the mine in his land, the author of book possesses right over his book. When the rights are leased the owner receives a consideration for the same which is called royalty.

Royalty is a periodical sum based on the output payable by the lessee to the lessor for having utilized the rights of the lessor. The person who makes the payment to the owner of asset is known as lessee and the owner of the asset is known as lessor. Royalty is a business expense and closed and transferred to profit and loss account.

According to William Pickles, “Royalty is the remuneration payable to a person in respect of the use of an asset, whether hired or purchased from such person, calculated by reference to and varying with quantities produced or sold as a result of such asset.”

Table of Contents

1. Introduction to Royalty Accounts 2. Types of Royalty Accounts 3. Importance and Advantages of Royalty Accounts 4. Difference between Royalty and Rent 5. Minimum Rent – Meaning, Importance and difference between Minimum Rent and Royalty 6. Adjustments of Minimum Rent in Case of Strike/Lock out 7. Short workings and Its recoupment 8. Surplus 9. Nazrana or Salame 10. Sub – Lease 11. Income Tax on Royalty 12. Accounting Treatment of Royalty – Journal Entries ALSO READ: ROYALTY ACCOUNTS MULTIPLE CHOICE QUESTIONS (MCQs) ALSO READ: ROYALTY ACCOUNTS ONLINE TEST

Types of Royalties:

There are many types of royalties but following types of royalty are very popular:

a)      Mining Royalties,

b)      Brick-making Royalties,

c)       Oils-wells Royalties,

d)      Patent Royalties

e)      Copyright Royalties

Importance of Royalty Accounts

The main advantages of Royalty accounts are:

1.       Accounting information is used by the lessor in calculating the amount due from the lessee.

2.       It helps in ascertaining the actual cost of production because the royalties paid on production is a direct expense.

3.       Royalty accounts helps in knowing the amount of tax be deducted before payment of royalty to lessee.

4.       In case of sub-lease, Accounting supplies through royalty accounts helps in settlement of claims between lessor, lessee and sub lessee.

Difference between Royalties and Rent:

In the common usage, the term royalty is used to mean rent. But there is some difference between royalty and rent. The following are the major difference between royalty and rent:

S.N.	Royalty	Rent
1. Type of Assets	Royalty is the consideration payable for the use of special right for both tangible and intangible assets.	But rent is the consideration payable for the use of only tangible assets.
2. Basis of Calculation	Royalty is paid either on the basis of output or sale.	Rent is paid on the basis of period.
3. Variability	Royalty varies on the basis of output or sales.	Rent is fixed.
4. Minimum Rent	Royalty agreement normally contains a clause to pay a minimum rent.	But in rent, there is no concept of minimum rent.
5. Parties	Parties are known as lessor and lessee.	Parties are known as tenant and landlord.

 Minimum Rent:

Minimum Rent is the amount below which landlord never accepts in any year from the person who has to pay royalty in case of mines. Minimum Rent is also known as Fixed Rent, Dead Rent, Flat Rent or Contract Rent. If in any year amount of royalty is less than the amount of minimum rent, the amount of minimum rent is payable by the person who has to pay the royalty, but if the amount of royalty is more than the amount of minimum rent, royalty will be paid.

Importance of Minimum Rent in Royalty Accounts:

Fixation of minimum rent is in the interest of landlord because it guarantees him the receipt of the minimum rent even in the case of low output or sales. In the absence of minimum rent clause, only the actual royalty will be paid to the landlord. Moreover, it also gives incentive to the lessee to enhance production or sales because he is bound to pay minimum rent.

Redeemable Minimum Rent:

Generally, when minimum rent is more than royalty, then minimum rent is payable if no such provision is given in the agreement, but if it is mentioned in the agreement that when royalty will be more than minimum rent, the excess of minimum rent over royalty paid in the earlier years will be written off out of the excess of the royalty over minimum rent in the coming years such minimum rent is called Redeemable Minimum Rent.

Difference between Royalty and minimum rent

a) Calculation of royalty based on output or sales, but minimum rent is fixed.

b) In every lease agreement, payment of royalty is compulsory but the provisions of minimum rent may or may not be applicable.

c) Royalty is transferred to production or profit & loss account , but minimum rent is not transferred to royalty account.

Adjustments of minimum rent in case of strike / Lockout / Accident

Normally minimum rent is fixed taking into consideration the minimum expected output under normal condition. But if there is stoppage of work due to strike, lockout or other abnormal reasons, the minimum rent is required to be adjusted as provided for in the agreement. Minimum rent adjustments are done in the following manner:

a) Minimum rent is reduced by a fixed percentage. E.g. if minimum rent is Rs. 20,000 and due to strike it is reduced by 30%, then revised minimum rent will be: 20,000 – 30% = 14,000.

b) Minimum rent is reduced To a fixed percentage. E.g. if minimum rent is Rs. 20,000 and due to strike it is reduced to 60%, then revised minimum rent will be: 20,000*60% = 12,000.

c) Minimum rent is reduced by a fixed percentage of the period of lockout. E.g. if minimum rent is Rs. 20,000 and due to strike of 3 months it is reduced by 30% of the period of lockout, then revised minimum rent will be: 20,000 – [(20,000*3/12)30%] = 18,500.

d) Minimum rent is reduced proportionately to the length of the stoppage of work during the relevant year. E.g. if minimum rent is Rs. 20,000 and due to strike for three months it is reduced proportionately, then revised minimum rent will be: 20,000*9/12 = 15,000.

e) The minimum rent clause is not applicable in case of strike or lockout. E.g. if minimum rent is Rs. 20,000 and due to strike the actual royalties for the year will discharge all rental obligations. In such case actual royalties will be equal to minimum rent and hence there will be no surplus or short workings.

Short workings

The excess of minimum rent over royalty is called ‘Short workings’. It is calculated with the help of following formula: Minimum Rent – Royalty = Short workings. Normally, Short workings arise during gestation period or due to abnormal working conditions or during the early periods of lease as the activity level is low in that period.

Short workings should be carried forward and shown on the assets side in the Balance Sheet so long as they are recoverable and Short workings which could not be recouped during the allowed period of recoupment should be closed by transferring to profit and loss account. If there is no provision in the royalty agreement for recoupment of Short workings, the same should be transferred to profit and loss account in the year of the Short workings. The questions of Short workings or its recoupment does not arises if the royalty agreement does not contain a clause of minimum rent.

Right of Recoupment of Short workings

Recoupment of short working refers to recovering the short working of any year, from surplus royalty of the succeeding years. The right of recoupment of Short workings can be:

a)      Restricted or Fixed period or

b)      Unrestricted or Floating period.

When the lessee gets the right of recoupment of Short workings for a certain period (say first five years of the lease) commencing from the date of the royalty agreement, the right is said to be restricted or fixed. Any Short workings arising beyond this period cannot be reimbursed. But when the lessor allows the lessee to recoup any Short workings within two or three subsequent or following years, then the right is said to be unrestricted or floating because this can be availed of in any year when Short workings arises.

Recoupment or Writing off Short workings:

Short workings can be recouped only when there is surplus. The Recoupment  may be permitted over a stipulated period of time (fixed Recoupment) or over a specified period following the year of short working (floating Recoupment) or within the life time of the lease(Recoupment within life time of the lease). All the conditions regarding recoupment or writing off Short workings are based on the mutual agreement between the lessee and lessor. If Short workings could not be recouped within the agreed period, it will be transferred to profit and loss account in the year in which the right of recoupment is lost. By this process, Short workings account gets closed and will not appear as an asset in the balance sheet.

Surplus

The excess of royalties over minimum rent is called surplus. It is calculated with the help of the following formula: Royalties – Minimum Rent = Surplus. Surplus are utilised for recoupment of Short workings only.

Nazrana or Salame

In some cases, the lessee may agree to pay lump sum amount to the lessor in addition to royalty. This extra payment in addition to royalties is known as Nazrana or Lease Premium or Goodwill. Under such a situation a Nazrana account is opened in the books of the lessee and lessor. In the books of the lessee, the whole amount of Nazrana is debited to ‘Nazrana Account’ and is written off during the period of lease by transferring equal amount to profit and loss account. It the books of the lessor, it is credited to Nazrana account and an equal amount is transferred to profit and loss account every year. The balance in Nazrana account is shown as an asset in the books of lessee and as a liability in the books of the lessor.

Sub-Lease:

Sometimes a lessee grants a sub-lease to another person either for the whole land or for the portion of it. The person, to whom a sub-lease is granted, is called sub-lessee. In such a case production or sales by the sub-lessee under sub-lease will be considered to be production or sales under the original lease and royalties payable to the original landlord will be calculated on the basis of total production or sales of both the lessee and the sub-lessee.

In case of sub-lease agreement, the status of original lessee will be twofold as lessee paying royalties to the landlord and as sub-lessor receiving royalties from the sub-lease. As lessee he maintained royalty payable a/c, Short Workings a/c and landlord a/c and as lessor for sub-lessee he maintains royalty's receivable a/c, short workings suspense a/c and sub -lessee a/c .The entries in the book at all the parties will be the same as above. To the original landlord Royalty should be paid on the basis of the total output of both the lessee and sub-lease.

Income Tax on Royalty

If there is a provision in the income tax law that the payer of royalty should deduct tax at source at the prescribed rate and tax so deducted shall be deposited to the credit of the central government within a specified time. The landlord will get the amount of royalty or minimum rent after adjustment of tax. The total amount of royalty (including tax) will be charged to profit and loss account or production a/c.

Royalty – Accounting Treatment

To record transactions relating to royalty accounts, journal entries are passed in the books of both lessor and lessee. In the books of lessee journal entries are passed in two different ways – without minimum rent account and with minimum rent account.

Royalty Accounts Journal Entries in the books of lessee

a)      When minimum rent account is not opened

Sl. No.	Circumstances	Royalties are less than the minimum rent	Royalties are more than the minimum rent
01	For Royalty payable	Royalties a/c                    Dr Short working a/c            Dr                   To Land lord a/c	Royalties a/c                     Dr              To Short working a/c              To Land lord a/c
02	For payment of royalty	Land lord a/c     Dr To Bank a/c
03	For transfer of royalty	Profit and loss a/c      Dr To Royalty a/c
In case short working is not completely recovered (non-recovery of short working)
04	For transfer of short-working	Profit and loss a/c                Dr                To Short working a/c

b)      When minimum rent account is opened

Sl. No.	Circumstances	Royalties are less than the minimum rent	Royalties are more than the minimum rent
01	For minimum rent payable	Minimum rent a/c        Dr                To land lord a/c	No entry
02	For Royalty payable	Royalties a/c                     Dr Short working a/c              Dr To minimum rent  a/c
03	For payment of royalty	Land lord a/c       Dr To Bank a/c
04	For transfer of royalty	Profit and loss a/c   Dr To Royalty a/c
In case short working is not completely recovered (non-recovery of short working)
05	For transfer of short-working	Profit and loss a/c            Dr             To Short working a/c

Accounting entries in the books of lessor

Sl. No.	Circumstances	Royalties are less than the minimum rent		Royalties are more than the minimum rent
01	For Royalty receivable	Lessee’s a/c Dr     To Short working suspense a/c     To Royalties receivable a/c		Lessee’s a/c Dr  Short working suspense a/c Dr        To Royalties receivable a/c
02	For receipt of royalty	Bank a/c             Dr To Lessee’s a/c
03	For transfer of royalty	Royalty receivable a/c    Dr To Profit and loss a/c
In case short working is not completely recovered (non-recovery of short working)
04	For transfer of short-working		Short working suspense a/c      Dr To Profit and loss a/c

Table analysis

Year	Output	Minimum rent	Royalty	Short working	Short working recovered	Short working not-recovered	Amount paid to landlord
01	02	03	04	05	06	07	08
				(3-4=5)	(4-3=6)	(5-6=7)	(4+5=8) or (4-6=8)