Royalties: Do You Really Know How Royalties Impact Your Business?
MetaComet’s David Marlin shares advice for simplifying the royalty accounting process. This article initially appeared on the Independent Publishers Guild’s website.
Sales coming in. Contract clauses invoked. Royalties calculated. Payments made. Complex accounting. The whole royalties process can be overwhelming. In the midst of the chaos, all these events are impacting your business in significant ways. But do you really know how?
Fortunately, with the help of basic accounting principles, we can learn to understand the effects. As the designer of multiple royalty management tools to automate otherwise complicated accounting transactions, my objective here is to provide a basic overview of how royalty accounting affects your business. Disclosure: I am not a certified accountant and can’t certify the details below, so please consult with one before making decisions based on this information.
If you feel overwhelmed, you are in good company. But to keep it as simple as possible, there are two basic account statements that on paper best illustrate the impact of royalties on your business: income statements, which show how they affect your company’s profitability; and balance sheets, which show they affect your company’s value. Each line on these represents an ‘account’. For example, you keep track of your cash in a ‘Cash account’, and of how much you are owed in an ‘Accounts receivable’ account.
On a balance sheet, there are two types of accounts:
- Assets: Things that add value to your business, like cash
- Liabilities: Things that detract value from your business, like royalties due.
On an income statement, there are similarly two types of accounts:
- Revenue accounts: Money coming in to increase your profitability
- Expense accounts: Money going out to decrease your profitability.
Every financial action in your business is added to your ledger and results in simultaneous changes to at least two accounts, but it’s not always clear whether these are increasing or decreasing an account’s value. It’s pretty confusing. To help us learn, let’s take an example.
A royalty accounting case study
Imagine that your newly released, internationally acclaimed title A Guide to Simple Royalty Management has just earned its first sales. Your distributor has informed you that it has sold 10,000 copies in its first day, generating £100,000 of revenue.
You might now enter this activity in your ledger, and looking at the entries shows exactly how it impacts your company’s value and profitability. The first entry is to record the sale like this:
- Debit (increase) Accounts Receivable by £100,000. This indicates the money that is owed to you but hasn’t yet been paid. As an asset it increases the value of the business.
- Credit (increase) Sales by £100,000. Sales is an expense account, meaning this also represents an increase to profitability.
For the second entry, let’s assume you owe a 10% royalty of £10,000:
- Debit (increase) Royalty Expense by £10,000. This expense account item represents a decrease to your profitability
- Credit (increase) Accrued Royalty by £10,000. This is money you owe, a balance sheet account, which in turn decreases your value.
At this point, you may need to apply reserves against returns of your books. Assume you withhold 20%. 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:
- Debit (decrease) Accrued Royalty by £2,000
- Credit (increase) Royalty Reserve Payable by £2,000.
If you have paid out advances, you will now recoup those. Let’s assume you have paid a £1,000 advance:
- Debit (decrease) Accrued Royalty by £1,000. This is £1,000 less in royalties you need to pay. You have lowered your liability, which would appear to increase your company’s value
- Credit (decrease) Prepaid 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.
Notice that 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.
Now let’s see what happens when you pay your author. Assume that the royalty period has ended, and that your initial sale of 100,000 copies was the only one to come in. 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 is subtle, and doesn’t impact your company’s value or profitability, because we are just shifting money from one type of owing to another:
- Debit (decrease) Accrued Royalty by £7,000 (£10,000 royalty less £2,000 reserve for returns less £1,000 advance)
- Credit (increase) Royalty Payable by £7,000.
One might ask: why bother with this prior step? At this point, you might release reserves as Royalties Payable. There may also be adjustments from errors in prior periods. I am not showing those steps here, so just understand that there is other activity that can impact the royalties you must pay. The Royalty Payable account helps distinguish that from straight royalties.
Finally, let’s pay the author. Here’s the most relevant transaction:
- Debit (decrease) Royalty Payable by £7,000. Once the payment is made, the royalties we owe go down.
- Credit (decrease) 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.
Excluding all non-royalty expenses, the transaction in our example has grossed £90,000 in profit. In turn, it has increased the company’s value by that same £90,000. We can also now easily see what our reserve balance is, and the level of pre-paid royalties—which is negative here because we did not include the creation of the initial advance.
This is a simple example, but it does help to demonstrate the impact of royalties on a business.
Download a free copy of MetaComet’s Royalty Automation Handbook and see how you can reduce your effort by up to 90%, simplify your processes and maximize accuracy in your royalty accounting.
To learn more about Royalty Tracker, Rights Tracker, or AuthorPortal.com, contact MetaComet.