Comprehensive Guide to Royalty Accounts

Introduction to Royalty Accounts

Royalty accounts deal with special rights possessed by individuals over certain properties or intellectual creations. These rights can be exercised by the owners themselves or leased to others for a consideration.
Examples of special rights include:
- A landlord possessing exclusive rights over a mine or quarry on their land.
- A patentee who has invented something new and holds exclusive rights over the patent.
- An author holding exclusive copyright over a written work or book.
A Royalty Agreement comes into existence when these special rights are given to another person on a lease basis for consideration.
The agreement involves two primary parties:
- Lessor (Landlord/Patentee/Author): The person who gives out special rights to another for consideration.
- Lessee (Tenant/Patentor/Publisher): The person who takes special rights from an owner on lease for consideration.

Key Terms in Royalty Agreements

Landlord: The person granting special rights (mining, patent, or copyrights) to another for consideration. Synonyms include lessor, patentee, or author.
Lessee: The person acquiring rights for consideration. Synonyms include tenant, patentor, or publisher.
Royalty: A periodical payment based on output or sales for the use of a certain asset or right (mine, copyright, or patent). It is an expense for the lessee and income for the lessor.
Ground Rent (Surface Rent): A fixed yearly or half-yearly rent payable by the lessee to the landlord in addition to the minimum rent.
Minimum Rent (Dead Rent/Fixed Rent): A clause ensuring the lessor receives a minimum amount regardless of production or sales levels. This protects the landlord against low output or deliberate under-utilization of rights by the lessee. The lessee pays the actual royalty based on output/sales or the minimum rent, whichever is higher.
Shortworkings: The excess of minimum rent over actual royalty calculated on the basis of output or sales.
- $\text{Shortworkings} = \text{Minimum Rent} - \text{Actual Royalty}$
- Shortworkings usually occur during the gestation period, early lease periods, or due to abnormal working conditions when activity levels are low.
Surplus: The excess of actual royalty over the minimum rent amount.
- $\text{Surplus} = \text{Actual Royalty} - \text{Minimum Rent}$
Right of Recouping Shortworkings: A clause allowing the lessee to recover excess payments (shortworkings) from surplus royalties in subsequent years. There are two types:
- Restricted (Fixed): The right of recoupment is limited to a specific period (e.g., the first four or five years of the lease).
- Unrestricted (Floating/Fluctuating): The lessee can recoup shortworkings within a specific number of subsequent or following years (e.g., within next two or three years) from whenever the shortworking arises.

Types of Royalties and Calculation Bases

Mining Royalty: Periodical payment based on output (e.g., quantity of coal or oil extracted) made by a lessee of a mine or quarry to the landlord.
Patent Royalty: Periodical payment based on output (manufacture) made by a lessee to a patentee.
Copyright Royalty: Periodical payment based on sales (number of books sold) made by a publisher to an author.
Bases for Calculation:
- Author of a book: Number of books sold.
- Owner of a mine: Quantity of coal produced.
- Scientist holding a patent: Manufacturing output.
- Owner of an oil well: Quantity of oil extracted.

Nature of Royalty Accounts

Royalty is treated as ordinary business expenditure by the lessee and income by the lessor.
Royalty Account is a nominal account, closed at the end of every accounting year by transferring to functional accounts:
- Royalty based on output is transferred to Trading Account, Manufacturing Account, or Production Account (treated as cost of production).
- Royalty based on sales is transferred to Profit and Loss Account (treated as selling expenditure).
Capital Expenditure Note: A lump-sum payment for the outright purchase of a patent, mine, or book is recorded as a fixed asset rather than royalty expenditure.

Distinction Between Rent and Royalty

Nature of Assets:
- Rent: Consideration for the use of tangible assets (e.g., building, machinery).
- Royalty: Consideration for the use of special rights for both tangible and intangible assets (e.g., patents, copyrights).
Basis of Payment:
- Rent: Paid on a time basis (weekly, monthly, yearly).
- Royalty: Paid on the basis of production, yield, or sales.
Fixed or Variable:
- Rent: Generally fixed with regard to time.
- Royalty: Variable, calculated based on production/sales volume.
Minimum Rent:
- Rent: No concept of minimum rent.
- Royalty: Generally contains a minimum rent clause.
Parties:
- Rent: Tenant and Landlord.
- Royalty: Lessee/Publisher/Patentor and Lessor/Author/Patent Holder.

Accounting Treatment in the Books of the Lessee

Case I: When Actual Royalties are Less than Minimum Rent

Method 1: Minimum Rent Account is NOT Opened

Due Entry:
- Royalties A/c Dr. (Actual Royalty)
- Shortworkings A/c Dr. (Difference)
- To Landlord A/c (Minimum Rent)
Payment Entry:
- Landlord A/c Dr.
- To Bank A/c
Transfer Entry:
- Profit & Loss (or Production) A/c Dr.
- To Royalties A/c

Method 2: Minimum Rent Account IS Opened

Due Entry (Minimum Rent):
- Minimum Rent A/c Dr.
- To Landlord A/c
Allocating Minimum Rent:
- Royalties A/c Dr. (Actual Royalty)
- Shortworkings A/c Dr. (Difference)
- To Minimum Rent A/c
Payment and Transfer entries remain the same.

Case II: When Actual Royalties Exceed Minimum Rent (Recoupment)

Due Entry:
- Royalties A/c Dr. (Total Actual Royalty)
- To Landlord A/c
Recoupment/Payment Entry:
- Landlord A/c Dr.
- To Shortworkings A/c (Amount Recouped)
- To Bank A/c (Net Paid)
Transfer Entry:
- Profit & Loss (or Production) A/c Dr.
- To Royalties A/c

Case III: Writing Off Shortworkings

If shortworkings are no longer recoupable (lapse of time or agreement limit), they are transferred to the Profit and Loss Account:

Profit & Loss A/c Dr.
To Shortworkings A/c

Accounting Treatment in the Books of the Lessor

In the books of the lessor, the focus is on Royalties Receivable and Shortworkings Suspense Account (or Royalty Suspense).

Case I: Royalties Received are Less than Minimum Rent

Due Entry:
- Lessee A/c Dr. (Minimum Rent)
- To Royalties Receivable A/c (Actual Royalty)
- To Shortworkings Suspense A/c (Difference)
Receipt Entry:
- Bank A/c Dr.
- To Lessee A/c
Transfer Entry:
- Royalties Receivable A/c Dr.
- To Profit & Loss A/c

Case II: Royalties exceed Minimum Rent (Lessee Recoups)

Due Entry:
- Lessee A/c Dr. (Actual Royalty)
- To Royalties Receivable A/c
Adjusting Suspense:
- Shortworkings Suspense A/c Dr.
- To Lessee A/c
Receipt of Balance:
- Bank A/c Dr.
- To Lessee A/c

Special Adjustments

Stoppage of Work (Strike, Lockout, Accident)

Royalty agreements usually provide for the adjustment of minimum rent in case of abnormal work stoppages. Common arrangements include:

Non-application: The minimum rent clause is suspended; actual royalties serve as the full obligation.
Pro-rata Reduction: Minimum rent is reduced in proportion to the duration of the stoppage.
- Example: If strike lasts $2$ months, minimum rent becomes $\frac{10}{12}$ of the annual amount.
Fixed Percentage Reduction: Minimum rent is reduced by a fixed percentage (e.g., $25 \%$ ) for that specific year.

Nazrana (Lease Premium)

Lessees may pay a lump-sum amount at the start of the lease in addition to royalties. This is known as Nazrana, lease premium, or goodwill.

Lessee's Books: It is capital expenditure. A Nazrana Account is debited. It is written off annually to Profit & Loss over the lease period.
Lessor's Books: It is credited to a Nazrana Account (Liability) and recognized as income (Profit & Loss) proportionately over the lease life.

Copyright Royalty Calculations

For book royalties, the number of units sold is calculated as follows:

$\text{Opening Stock of Books} + \text{Number of Books Printed} - \text{Specimen Books} - \text{Waste Books} - \text{Closing Stock of Books} = \text{Number of Books Sold}$
Royalties are calculated as a fixed percentage of the printed sale price of the total books sold.

Damages and Compensation

An author may be required to pay damages to a publisher for delays in revising a manuscript. These damages are typically set off against royalty payments receivable by the author.

Publisher's Books:
- Author A/c Dr.
- To Damages Receivable A/c
Author's Books:
- Damages Payable A/c Dr.
- To Publisher's A/c

Sub-Lease (Sub-Royalty)

Occurs when a lessee sub-lets a portion of their right to a sub-lessee.
The original lessee acts as a middleman:
- As Lessee to the Landlord: Maintains Royalties Payable A/c and Shortworkings A/c.
- As Sub-Lessor to the Sub-Lessee: Maintains Royalties Receivable A/c and Shortworkings Suspense A/c.
Total Production: Royalties payable to the original landlord are calculated on the basis of total production/sales of both the lessee and the sub-lessee.

Provision Against Shortworkings

If the recovery of shortworkings is uncertain, a provision (Shortworkings Reserve Account) can be created by debiting the Profit & Loss Account in the year shortworkings arise. When recouped or written off, the provision is adjusted accordingly via the Profit & Loss Account.

Numerical Illustration Specifics

Scenario 1: Pro-Rata Minimum Rent (Illustration 12)

Terms: Royalty $2 \text{ per ton}$ . Minimum Rent $9,000 \text{ per annum}$ . Right of recoupment for first $4$ years.
Strike Adjustment: Strike for $2$ months in $2013$ . Minimum rent calculation: $9,000 \times \frac{10}{12} = 7,500$ .
Lockout Adjustment: Lockout for $2$ months in $2014$ with a $40 \%$ concession policy. Benefit duration: $40\% \text{ of } 2 = 0.8$ . Paid for $11.2$ months. Calculation: $9,000 \times \frac{11.2}{12} = 8,400$ .

Scenario 2: Depletion Method Depreciation

Capital expenditure on land development (Nazrana) is not royalty but impacts accounts through depreciation.
Rate per tonne = $\frac{\text{Cost of Development}}{\text{Estimated Deposits}} = \frac{2 \text{ crores}}{20 \text{ lakh tonnes}} = 10 \text{ per tonne}$ .