Businesses that earn revenue by letting others use their intellectual properties, such as copyrights or patents, can track those earnings with an accounting practice known as royalty revenue recognition. With this method, revenue is “recognized,” or recorded, by following the terms of a royalty agreement, and the revenue is usually tied to how much a licensee sells or uses an asset. Income is recognized when revenue is clear and measurable, and therefore depends on a licensee's sales or usage reports.

The goal of royalty revenue recognition is to ensure that revenue is recognized only when the business has earned it. This accounting practice is particularly relevant for industries, such as music, that rely heavily on royalties. Copyright collective PRS for Music, for example, paid over £943 million in royalties to songwriters, composers, and music publishers in 2023.

Below, we’ll explain the details of royalty revenue recognition.

What’s in this article?

• Types of royalty agreements
  
• Royalty revenue recognition principles
  
• Challenges in royalty revenue recognition
  
• How to account for royalty revenue
  

Types of royalty agreements

Royalty agreements generally fall into certain categories, each tailored to the specifics of an asset and the relationship between a licensor and licensee. In all cases, the licensee pays some portion of their profits to the licensor for sales of goods or services that use the licensor’s intellectual property. Here’s a rundown of common types of royalty agreements.

• Revenue-based royalties: Royalties are a percentage of revenue.

• Unit-based royalties: Royalties are based on the quantity of units sold.

• Fixed royalty agreements: Royalties are a fixed amount per unit or per period, regardless of sales volume or revenue.

• Minimum guarantee with overage: Royalties are set at a minimum, regardless of sales; if sales exceed a certain threshold, additional “overage” royalties are paid based on a predetermined formula.

• Step royalties: Royalty rates change based on sales thresholds. For example, the rate might increase as sales volume surpasses a certain figure.

• Net profit royalties: Royalties are calculated from net profits rather than gross revenue. This approach takes into account certain deductions for costs directly associated with production and sales.

• Hybrid royalties: Royalties are determined by a combination of factors. For example, royalties might include both a fixed payment and a revenue-based component.

Royalty revenue recognition principles

Revenue earned from royalties is recognized in accordance with accrual accounting principles, where revenue is recognized when it is earned, regardless of when cash is received. For royalties, this means that income is recorded during the period that a licensee uses a licensed asset and generates sales or other revenue from it; this might not be the same period in which payments are made. This accounting practice ensures that financial statements reflect the true economic activity and health of a business by matching the revenue earned with the expenses incurred to generate that revenue within the same period.

Royalty revenue recognition also follows accounting standards such as Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). Key factors include:

• Performance: Royalty revenue can be recognized when the performance obligations of the royalty agreement are satisfied. This usually occurs as a licensee sells or uses a product that incorporates a licensor’s intellectual property.

• Measurability: Revenue can be recognized when it is measurable with a high degree of precision. This typically means having reliable sales or usage reports from a licensee that detail how a licensed asset is being used.

• Reasonable certainty: Revenue can be recognized when there is reasonable certainty about the collection of the royalty payments. If there is major uncertainty about the collectability of the revenue, recognition might need to be deferred until the uncertainty is resolved.

Challenges in royalty revenue recognition

Royalty revenue recognition comes with certain challenges.

• Variable payments: Many royalty agreements include payments that vary based on metrics such as sales volume or product usage. This variability can make it difficult to accurately estimate and recognize revenue, especially when payments fluctuate over time.

• Uncertain sales data: Dependence on a licensee for sales or usage data adds a layer of uncertainty. If the licensee’s reporting is delayed or inaccurate, it can complicate revenue recognition timing and accuracy.

• Complex contract terms: Royalty agreements often come with complicated terms, including thresholds and different rates dependent upon various conditions. It can be challenging to interpret these terms and apply them consistently in financial statements.

• International considerations: For licensors with international licensees, there are additional concerns, such as exchange rate fluctuations, differing tax regimes, and varied compliance requirements across jurisdictions. These factors can all affect how royalties are calculated and recognized.

• Auditing and compliance: Businesses must have thorough documentation that can serve as audit trails to demonstrate compliance with accounting standards. Auditors must be able to verify that the royalty calculations align with both the contractual terms and recognized accounting practices, which can be a detailed and time-consuming process for the business to maintain.

• Technological tracking: In industries such as software or digital content, tracking asset usage can be technologically demanding. Businesses must invest in systems that accurately capture how and how much of a licensed material is being used.

• Revenue forecasting and planning: The uncertainty and variability of royalty income can make financial planning and forecasting more difficult. Businesses must often make educated guesses about future earnings, which can impact budgeting and financial strategy.

How to account for royalty revenue

Here's a step-by-step breakdown of how to recognize royalty revenue.

• Review and understand the agreement: Begin by reviewing the royalty agreement to understand the terms, including the basis for payments (e.g., revenue-based, unit-based), rates, and any minimum guarantees or thresholds.

• Determine the performance obligations: Identify what actions or performance obligations must be completed to earn royalties. In most cases, the obligation is tied to the licensee’s sales or usage of the licensed product.

• Track and report usage or sales: Implement a system for tracking the licensee's sales or usage that generates royalty payments. This process often requires cooperation from the licensee to provide accurate and timely data.

• Calculate royalties: Use the data received to calculate the royalties that are due based on the agreed terms. Adjustments might be needed for returns, allowances, or reaching certain thresholds.

• Recognize revenue: Once the performance obligations are satisfied and the royalty amount is determinable, recognize the revenue.

• Prepare for adjustments: Be prepared to adjust royalty revenue recognition if initial estimates based on licensee projections or forecasts differ from actual sales reported.

• Document and disclose: Ensure all calculations and assumptions are well-documented for auditing purposes. Include proper disclosure in financial statements, especially regarding contingent liabilities or variable considerations.

Sample scenario

Imagine that a software business licenses its patented technology to a medical device business. The royalty agreement stipulates a 5% royalty on all net sales of the devices that use the software business’s technology, and royalties are payable quarterly. Here’s how both businesses would recognize this royalty revenue.

• The software company, the licensor, reviews the agreement to confirm the 5% rate on net sales and the quarterly payment schedule.

• The software business identifies the primary obligation as the continued functionality and legal protection of its technology. The medical device business, the licensee, is responsible for reporting sales accurately.

• The medical device company implements a tracking system within its sales software to report the sales data back to the software company.

• At the end of the first quarter, the medical device company reports $2 million in net sales of its devices. The software company calculates the royalties as 5% of $2 million, equaling $100,000.

The software business recognizes $100,000 in royalty revenue for the first quarter, as the performance obligations have been met and the royalty amount is clearly determinable and reasonably assured.

• The software company documents all calculations and maintains records of the sales reports from the medical device company. In their financial statements, they disclose the nature of the royalty income and any major changes in royalty rates or sales volumes.

• In subsequent quarters, if sales data indicates returns or adjustments, the software company will modify the royalty calculations accordingly.