Businesses that sell licensed products, from branded merchandise to software built on third-party technology, owe royalties to the rights holder. Licence agreements usually require a royalty report and payment a month or two after each quarter, which means the books need an accrual for royalties earned but not yet invoiced or paid.
Accounts
| Account | Type |
|---|---|
| Royalties payable (expense) | cost of sales, if royalties vary with units sold |
| Royalty accruals | current liability |
| Royalty advances | asset, for advances that will be recouped from future royalties |
Calculating the accrual
Most agreements set the royalty as a percentage of net sales or a fixed amount per unit. At the period end:
- Take the sales of licensed products for the period from the sales system.
- Apply the royalty rate in the agreement (on the defined base, often net of returns and discounts).
- Deduct anything already paid for the period.
A company sells £60,000 of licensed products in the quarter at an 8% royalty on net sales:
| Account | Debit | Credit |
|---|---|---|
| Royalties payable (cost of sales) | £4,800 | |
| Royalty accruals | £4,800 |
When the licensor’s invoice arrives the accrual is cleared.
Minimum guarantees and advances
Many licences require a minimum guarantee: a royalty payable even if sales are lower. If sales are falling short, accrue enough to cover the minimum for the period it relates to. An advance paid on signing is an asset that is used up as royalties are earned against it; if sales will clearly never recoup it, write down the unrecoverable part.
VAT and overseas licensors
Royalties paid to a UK licensor carry VAT if the licensor is registered. Royalties paid to overseas licensors fall under the reverse charge for a VAT-registered business. Royalties paid by a UK company to a non-resident may also require deduction of income tax at source unless a tax treaty reduces it and the right procedure is followed; check before the first payment.
Checks
- Royalty base in the accrual matches the definition in the contract.
- Royalty reports sent to the licensor agree with the ledger.
- Advances are reviewed for recoverability each year end.
For other period-end estimates see accruals and prepayments; for royalties you pay as a cost generally, professional fees.