ICWAI | CMA Important notes on Royalty Accounts
ICWAI | CMA Important notes on Royalty Accounts – Here we are providing ICWAI | CMA Important notes on Royalty Accounts.
Definition of Royalty
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.
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 are:
- Mining royalty – to extract mineral and ore from earth
- The book publisher gives gratuity to the author / writer
- For the use of a design
ICWAI | CMA Important notes on Royalty Accounts royalty agreement will normally contain clauses dealing with the following:
- Minimum rent – guaranteed amount which the landlord, inventor or author is to receive whatever the output maybe.
- Royalty per unit per output
- Right to recoup short-workings
- Right to subject part or whole of tenancy agreement
ICWAI | CMA Important notes on Royalty Accounts Royalty Accounts: Meaning and Treatment (With Journal Entries)
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 theminimum 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.
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.
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.
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.].
ICWAI | CMA Important notes on Royalty Accounts | ADVERTISEMENTS:
It can be presented in the following manner:
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.
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.
CMA Important notes on Royalty Accounts
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.
ICWAI | CMA Important notes on Royalty Accounts
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:
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.
Students are advised to prepare the following chart before making actual attempt for
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.
Recognition of Royalty as a Revenue Ind AS-18:
As per Ind AS-18, Revenue Recognition, revenues arising from the use by others of enterprise recourses yielding interest, royalties and dividends should only be recognised when no significance uncertainty as to measurability or collectability exists.
These revenues are recognised on the following basis:
In case of Royalty:
On the Accrual Basis in accordance with the terms of the relevant agreement.
It becomes clear from the above that royalty receivable should be recognised as revenue.
CMA Important notes on Royalty Accounts | Illustration 1:
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.
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.
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).
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).
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.
As there was no short-workings landlord will get Rs. $0,000 i.e., actual royalty or minimum rent whichever is higher.
When Minimum Rent Account is opened:
Entries in the books of Lessee/Licence/Users:
This method is particularly applicable when Actual Royalty is less than Minimum Rent.
CMA Important notes on Royalty Accounts | Illustration 2:
Applying Minimum Rent Account Method:
M. Ltd leases a property from Sri D. Poddar at a royalty of Rs. 1.50 per ton with a Minimum Rent of Rs. 10,000 p.a. Each year’s excess of Minimum Rent over royalties are recoverable out of royalties of next five years.
The results of working of the property are:
1998— As there was no royalty, the whole amount is treated as short-working and the same is carried forward.
1999— Actual royalty is less than the minimum rent by Rs. 6,700 (Rs. 10,000 – Rs.3, 300) and the same is again carried forward. Total amount of short-working was Rs. 16,700 (i.e., Rs. 10,000 + Rs. 6,700)
2000— Again there was a short-working of Rs. 1,000 (Rs. 10,000 – Rs. 9,000) which was again carried forward. Now, the balance of short-working was Rs. 17,700.
2001— Actual royalty is more than the minimum rent by Rs. 1,100 (Rs. 11,100 – Rs. 10,000) and the short-working were recoup by the like amount out of Rs. 10,000 of 1998.
Here, recoupment terms are very important. As per question, excess royalties are recoverable out of royalties of next five years. The word next is very significant here. It means, short-workings of first year should be recouped against the excess royalty of 2nd, 3rd, 4th, 5th and 6th year. Similarly, short-working of 2nd year should be recouped against the excess royalties of 3rd, 4th, 5th, 6th and 7th year and so on.
2002— So, again, as actual royalty is more than the minimum rent by Rs. 4,000 (Rs. 15,000 – Rs. 10,000) it should be recouped against the un-recoupable part of short-working of 1998. Still, there was a balance of Rs. 4,900 (Rs. 10,000 – Rs. 1,100 – Rs. 4,000) for 1998.
2003— In this year also, actual royalties are more than the minimum rent by Rs. 5,000 (Rs. 15,000 – Rs. 10,000) which should be recouped against the un-recoupable part of short-workings of 1998 i.e., Rs. 4,900 and Rs. 100 should be recouped against the short-working of Rs. 1,999.
Books of Lessors or Landlords or Authors:
CMA Important notes on Royalty Accounts | Illustration 3:
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 licence 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.
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)
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.
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.
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.
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.
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:
CMA Important notes on Royalty Accounts | Illustration 4:
Where there is no minimum rent clause:
X Ltd took a lease of coalfields from Y Ltd against a royalty of Rs. 10 per ton of coal raised. There was no minimum Rent Coal raised (in March) in tonnes. 2009—20,000 tonnes, March 2010—25,000 tonnes, and 2011—40,000 tonnes. Show the entries and necessary ledger accounts in books of X Ltd.
Strike and Lock Out:
In the event of strike or lock-out, if the Minimum Rent is not raised, the amount of Minimum Rent depends on the clause of the agreement between the two parties, i.e., Lessor and Lessee.
However, it may be treated in two following ways, viz., the clause may contain like the following:
(1) During strike or lock-out, the actual royalty earned will discharge all rental obligations (if actual royalty is less than Minimum Rent).
(2) During strike or lock-out, the Minimum Rent will be reduced proportionately having regard to the length of stoppage.
(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).
The following example will help to understand the principle clearly:
CMA Important notes on Royalty Accounts | Illustration 5:
In case of strikes, recoupment of short-working etc.:
P Ltd. took a mine on lease from Landlord at a given rate of royalty with a Minimum Rent of Rs. 12,000 per year. Each year’s excess of Minimum Rent over royalties is recoverable out of the royalties for the next two years. In the event of Strike, the Minimum Rent was to be reduced proportionately, having regard to the length of the stoppage. But in the case of Lock Out, it was provided that the actual royalties earned for the year would discharge the full rental obligation for that year.
The results of the workings were:
1. In case of Strike, the Minimum Rent should be reduced proportionately i.e., Rs. 12,000 x Rs. 9,000.
Minimum Rent for the 4th year will be Rs. 9,000 and, as actual royalty is Rs. 10,000, so Rs. 1,000 is recouped.
2. In case of lockout the actual royalties will discharge all rental obligation i.e., landlord will get only Rs. 8,000 for the 5th year although the Minimum Rent is Rs. 12,000.
3. Since in the first year the actual royalty is ‘Nil’ the entire amount is treated as short-working.
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:
CMA Important notes on Royalty Accounts | Illustration 6:
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.
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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