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Accounting 101: Understand How Royalties Impact Your Business

Royalty accounting can be a complex business. Numerous sources of sales, intricate contract clauses, complex calculations and multiple payments mean it can be easy to feel overwhelmed. Don’t worry; you’re not alone! Royalties have a significant impact on any business, therefore it is crucial to understand exactly how they are affecting your cashflow and value. 

There are two basic accounting statements that can illustrate the impact of transactions like royalties on your business. First, there are income statements, which will show how they affect your company’s profitability. Second, there are balance sheets, which will show how they affect your company’s value.

Each of these statements has two key elements. Income statements comprise of revenue accounts, which show the money coming in to your business; and expense accounts, which show the money going out. The difference between the two is your profitability. On a balance sheet, there are assets – the things that add value to your business, like cash; and liabilities – the things that detract value from your business. Liabilities include royalties that are due to be paid.

All of your financial transactions make a difference to your accounts – but it’s not always clear whether they increase or decrease the value of your business. To help understand this better, let’s take an example of accounting in five steps.

Step one: Sales

One of your books – we’ll call it The Guide to Better Royalty Management – is selling well. Your distributor has told you that it has sold 10,000 copies and earned $100,000 in revenue. This has two implications for your accounts: 

  • Increase (debit*) Accounts Receivable by $100,000. This is the money that is owed to you, but that hasn’t yet been paid. It’s an asset, so it increases the value of the business on the balance sheet.
  • Increase (credit*) Sales by $100,000. Sales is a revenue account, meaning this also represents an increase to profitability. 

Step two: Calculating royalties

Now for the royalty part. Let’s assume you pay a royalty rate of 10%. This means you owe the author of The Guide to Better Royalty Management $10,000. This has two implications for your accounts: 

  • Increase (debit) Royalty Expense by $10,000. This expense account item represents a decrease to your profitability.
  • Increase (credit) Accrued Royalty by $10,000. This is money you owe, so it decreases the value of your business on the balance sheet.

Step three: Reserves

At this point, you may need to apply reserves against possible returns of your books. Assume you withhold 20%, or $2,000. In this case, the impact to both your company value and your profitability is neutral. You are just moving money from one type of liability to another:

  • Decrease (debit) Accrued Royalty by $2,000
  • Increase (credit) Royalty Reserve Payable by $2,000

Step four: Recouping advances

If you have paid out advances, you will now recoup those. Let’s assume you have paid a $1,000 advance. The implications are:

  • Decrease (debit) Accrued Royalty by $1,000. This is $1,000 less in royalties you need to pay. You have reduced your liability, which increases your company’s value.
  • Decrease (credit) Pre-paid Royalty – where you would have originally recorded the advance – by $1,000. This is a decrease to an asset, as the author now owes you less. 

Recouping an advance doesn’t really impact your value or your profitability. You don’t have to pay the author as much – but they don’t owe you as much either.

Step five: Payments

Now let’s see what happens when you pay your author the royalties, based on the sale of 10,000 copies. The first thing to do is move the royalties owed from the ‘owed’ bucket (Accrued Royalty) to the ‘ready to pay’ bucket (Royalty Payable). This doesn’t impact your company’s value or profitability, because we are just shifting money from one type of owing to another:

  • Decrease (debit) Accrued Royalty by $7,000 ($10,000 royalty less $2,000 reserve for returns less $1,000 advance)
  • Increase (credit) Royalty Payable by $7,000.

Now we pay the author. Here’s the relevant transaction:

  • Decrease (debit) Royalty Payable by $7,000. Once the payment is made, the royalties we owe go down.
  • Decrease (credit) Cash. Since we have to pay it out, the cash on hand also goes down.

There is no net effect on your company’s value, and as we look back, we can see that most of the impacts on value and profitability happen early. After royalties, but before other expenses, the transaction in our example has grossed $90,000 in profit and increased the value of the company by the same $90,000. We can also now easily see our reserve balance, and the level of pre-paid royalties – which is negative here because we did not include the creation of the initial advance.

MetaComet can help make royalty accounting much easier, by automating complex calculations and enabling easy and fast payments to authors. Our Royalty Tracker® integrates seamlessly into your other systems too, dramatically reducing the time spent reconciling statements and updating financial ledgers. Contact us to learn how we can make your royalty accounting better.

* For people not familiar with accounting, ‘Credits’ and ‘Debits’ are confusing: sometimes they mean an increase, sometimes a decrease, depending on the type of account. If, like most of us, you’ve never studied accounting, just ignore the Credit and Debit.”
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