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Friday, April 13, 2012

Royalty Accounts

Unit – 4: Royalty Accounts
Introduction:
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.”
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
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:
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.
Shortworkings
The excess of minimum rent over royalty is called ‘Shortworkings’. It is calculated with the help of following formula: Minimum Rent – Royalty = Shortworkings. Normally, Shortworkings arises 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.
Shortworkings should be carried forward and shown on the assets side in the Balance Sheet so long as they are recoverable and Shortworkings 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 Shortworkings, the same should be transferred to profit and loss account in the year of the Shortworkings. The questions of Shortworkings or its recoupment does not arises if the royalty agreement does not contain a clause of minimum rent.
Right of Recoupment of Shortworkings
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 Shortworkings can be:
a)      Restricted or Fixed period or
b)      Unrestricted or Floating period.
When the lessee gets the right of recoupment of Shortworkings 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 Shortworkings arising beyond this period cannot be reimbursed. But when the lessor allows the lessee to recoup any Shortworkings 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 Shortworkings arises.
Recoupment or Writing off Shortworkings:
Shortworkings 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 Shortworkings are based on the mutual agreement between the lessee and lessor. If Shortworkings 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, Shortworkings 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 Shortworkings 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 two fold: 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, shortworkings 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.


 Accounting entries in the books of lessee
a)      Without 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)      With 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)


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