FINANCIAL ACCOUNTING -I

UNIT 04 Royalty Accounts:

4.1 Meaning of the term Royalty
4.2 Important Terms: Minimum Rent or Dead Rent, Short Workings, Recoupment of
Short Workings
4.3 Types of Problems:
4.3.1 Royalties without any Minimum Rent
4.3.2 Royalties with a Minimum Rent:
4.3.2.1 With the Lessee/Tenant having the right to recoup the Short
Workings:
4.3.2.1.1 Without any Limitation of Time
4.3.2.1.2 Within a Limited Time (Limitation of Time may commence either
from the Date of the Agreement or from the Date of Short Workings)
4.3.2.2 Without the Lessee having the right to recoup the Short Workings
4.3.3 Accounting Entries and Preparation of Ledger Accounts without Minimum
Rent Account and with Minimum Rent Account:
4.3.3.1 In the Books of Lessee / Tenant
4.3.3.2 In the Books of Lessor / Landlord
4.3.3.3 Sub-Lease: Meaning and Accounting Entries/Treatment

I. Meaning of the term Royalty

 The owner of an asset (e.g. mines, quarries, patent, copyright, etc), as a business
arrangement, may allow other party (lessee, licencee, publisher, etc) the right to use
that asset against some consideration. Such consideration is calculated with reference to
the quantity produced or sold. This payment to the owner by the user of the asset is
termed as Royalty.
 Royalty is the amount of consideration paid by a party to the owner of the asset in
return for the right to use that asset.
 Royalty is a periodical payment made based on output or sale for the use of certain asset
or right on certain assets like mine, copyright or patent to its owner.
  In lease contract, royalty is a common terminology. It is termed as the amount paid by
the lessee (user of lease asset) for using the property of lessor (owner of lease asset).
 Likewise, royalty is also paid by the publisher to the author of the book.
The following are some of cases where one party paid to another in the form of Royalty:
1. where the owner of a mine allows another the right to extract minerals from land;
2. where right such as patents or copyrights are licensed in favour of another;
3. where an author, artist or designer gives exclusive rights to another to copy the work.
II Important Terms:
A. Minimum Rent or Dead Rent,
 A contract is entered into between the landlord and the lessee for payment of
royalty, usually calculated upon the quantum of production or sale at a certain
stipulated rate.
So, if there is little or no production or sale, the landlord would receive little or no
royalty at all, thus affects the monetary interest of the landlord as well as the
lessee.
It is normally not acceptable to the owner, since sale or production mostly
depends on the capacity of the person to whom the rights have been given.
To avoid such a situation, the landlord and the lessee agreed upon a minimum
periodical amount that the landlord will receive from the lessee, even if the actual
royalty as calculated on the basis of actual production or sale is less than such
minimum amount. This assured and mutually agreed periodical minimum amount
is known as “Minimum Rent”.
 Royalty agreements are usually associated with a clause that the lessor or
landlord must receive a minimum amount irrespective of the production or sales
made by using the lease asset during a particular period.
 Such minimum amount is known as minimum rent or dead rent or fixed rent.
 The fixation of such rent is in the interest of landlord because it guarantees him
the receipt of the minimum amount in case of low output or sales.
 Further, it gives incentive to the lessee to increase the production or sales in the
initial period of lease agreement .

For example, M/S Kalyani Publishers printed a book on Advanced Accountancy at a

minimum rent of Rs. 20,000 p.a. royalty being payable @ Rs. 7.50 per copy sold and the
number of copies sold in the first year is 2,000 and in the second year is 4,000. In this
case M/S Kalyani Publishers will have to pay Rs. 20,000 to the authors as minimum rent
even though royalty works out to be Rs. 15,000 for 2,000 copies @ Rs. 7.50 per copy
 sold. In the second year Rs. 30,000 as royalty for 4,000 copies @ Rs. 7.50 per copy sold
will be paid to the authors even though the minimum rent is Rs. 20,000.

B. Short Workings,
Short workings is the amount by which the minimum rent exceeds the actual royalty. It is
the difference between Actual Rent and Minimum Rent.
The excess of minimum rent over actual royalty calculated on the basis of output or
sales is termed as short working.
In the example previous example, there was a short working of Rs. 5,000 i.e., (Rs.
20,000- Rs. 15,000). There was no short working in the second year.

C. Recoupment of Short Workings

Generally the royalty agreement contains a provision for carrying forward of short
workings with a view to adjust it in the future. In the subsequent years, such
shortworking is adjusted against the surplus royalty.

This process of adjustment is called recoupment of short workings. The right of

recoupment of short workings enables the lessee to recover the excess payment, made
in the earlier years to meet the condition of payment of minimum rent.

A time is usually agreed upon the number of years for which such short workings can be
recouped. This time limit for recoupment of short workings may be fixed or fluctuating.
If the short workings cannot be recouped within the specified time, they lapse and are
charged to Profit and Loss Account in the year when that specified time limit for
recoupment ends.

(i) Fixed right : When the lessee can recoup shortworkings within a certain period from
the date of the lease it is known as fixed right. For example, short workings can be
recouped within three years from the date of the lease. So, after three years from the
date of the lease the short workings cannot be recouped.

(ii) Fluctuating right : In this type of agreement, lessee can recoup short workings of any
year during the next following year(s). For example, shortworkings can be recouped in
the year subsequent to the year of short workings.
 It means the recovery of short workings of the previous years out of surplus royalty of
subsequent years. The following conditions can be there for the recouping of short
workings:
• The short workings are always recouped when there is surplus i.e., excess of royalty
over minimum rent
• The recouping of short working is to be done within the agreed period as given in the
agreement.
• If short workings could not be recouped within the agreed period, it will be transferred
to Profit and Loss Account.

D. Ground/ Surface Rent

It is the fixed yearly or half yearly rent payable by the lessee to the landlord in addition
to the minimum rent.

E. Nazrana or Lease Premium

In some cases, the lessee may agree to pay lump sum to the lessor in addition to royalty.
This extra payment in addition to royalty is known as lease premium.
F. Strike and Lockout, etc :
If agreement so provides, the minimum rent may be proportionately reduced in the event
of strike and/ or lockout. So special entry is required for the same except the adjustment of
minimum rent for that particular year.
Important Points to note :
1. When the royalty agreement does not contain a clause for minimum rent, the question of
short workings and its recoupment does not arise.
2. The landlord is always entitled to get either the minimum rent or the actual royalty
whichever is higher subject to any adjustment for short workings recouped.
Distinction between Rent and Royalty
Royalty is a different concept from conventional rent paid to the landlord. Some of the points
related to their differences are mentioned below:
Distinction between Rent Royalty
Rent and Royalty Basis
of difference
It is the consideration It is the consideration payable
payable for the use of only for the use of special right for
Nature of assets
tangible assets as building, both tangible and intangible
machinery, etc. assets.

Basis of payable It is mostly payable on the It is paid on the basis of

basis of time as weekly, production, yield or sale.
monthly or yearly.

Fixed or variable The amount of royalty is

The amount of rent is variable and is calculated in
generally fixed with regard accordance with production
to time. or sales.

Minimum rent There is no concept of

It generally contains a clause
minimum rent.
in the agreement to pay
minimum rent.

Parties
The parties are known as Parties are known as lessee/
tenant and landlord patent holder/ publisher/
lessor/ author, etc.
III Types of Problems:
Accounting Entries in the Books of the Lessee/Licencee/Publisher etc.
1. Where a minimum rent exists with right to recoup short workings
(a) Where the actual royalty is less than the minimum rent
(i) Royalties (payable) Account Dr. [Actual royalties for the period]
Short workings Account Dr. [Minimum rent - Actual royalties]
To Landlord Account [Minimum rent]
(ii) Landlord Account Dr. [Minimum rent]
To Bank Account [Net amount paid]
To Income Tax Payable Account [Tax deducted at source]
(iii) Manufacturing / Profit & Loss Account Dr. [Transfer]
To Royalties (payable) Account [Actual royalties for the period]

If the user is a manufacturer and royalties are calculated on the basis of production, the actual
royalties are debited to Manufacturing Account. Where royalties are calculated on the basis of
sales, they are debited to Profit and Loss Account.
In case of a limited company, which does not prepare Manufacturing Account separately, the
actual royalties are debited to Profit and Loss Account and they are shown in production or
manufacturing section of the Profit and Loss Account
Treatment of Short workings
As per agreed terms, short workings can be recouped in the year when the actual royalty is
more than the Minimum rent. Any short workings, which cannot be recouped within the
specified period becomes irrecoverable and it should be charged to Profit and Loss Account in
the year in which the period ends.
However, the recoupable short workings should be carried forward and they are shown in the
Balance Sheet as a Current Asset.
The relationship between Minimum rent, Actual Royalty and Royalty payable are in below :
Minimum rent = Actual Royalty + Short workings.
(b) Where the actual royalty is more than the minimum rent :
(i) Royalties (payable) Account Dr.
To Landlord Account
[Actual royalties for the period]

(ii) Landlord Account Dr.

To Short workings Account
(Short workings, if any, recouped)

(iii) Landlord Account Dr.

To Bank Account
To Income Tax Payable Account

(iv) Profit & Loss Account Dr.

To Short workings Account
(Short workings, which can not be recouped)

(v) Manufacturing / Profit & Loss Account Dr.

To Royalties (payable) Account

Important Points to note :

1. When the royalty agreement does not contain a clause for minimum rent, the question of
short workings and its recoupment does not arise.
2. The landlord is always entitled to get either the minimum rent or the actual royalty
whichever is higher subject to any adjustment for short workings recouped.

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