Royalty Accounting for Reserves

In royalty accounting a royalty reserve; also called a reserve for returns or reserve for royalties, is created when you withhold royalty earnings for a specified period to covered expected future returns from sales made in that period. It is a liability because you are obligated to pay the royalty recipient the reserve amount in a future period if the reserve is not earned out by future reductions to royalties.

Sample reserve for returns contractual clauses:

“The licensee may withhold a reasonable reserve for returns from customers. This reserve shall not exceed 15% of royalty earnings and the reserve will be withheld for no more than one accounting period.”

“The publisher may withhold a reserve for returns for customers purchasing physical products. This reserve shall be 40% of earnings during the first royalty period, 20% during the second royalty period and 0% during subsequent royalty periods. The reserve will be withheld for no more than one royalty period.”

Example:  On June 30 a reserve is withheld from the payment to the author

Account Debit Credit
Royalty Expense $100
Royalties Payable $90
Royalty Reserve $10

Trial Balance

AccountTypeBalance
Royalty Expense Cost of Sales $100
Royalties Payable Liability $90
Royalty Reserve Liability $10

On December 31 the reserve from June 30th is owed (“recovered”) to the author

Account Debit Credit
Royalty Reserve $10
Royalties Payable $10

Some companies will report only the net royalty payable as the expense for the period.

Incorrect:

Royalty Expense……..$75
………Royalties Payable…………..$75

This presentation is incorrect as it:

  1. Understates the royalty expense,
  2. Overstates income and
  3. Increases your income tax liability

Royalty accounting according to GAAP requires that you report your obligation to pay the reserve payment and the true royalty expense for the period.

Correct:

Royalty Expense……….$100
………..Royalties Payable……………$75
………..Royalty Reserve……………..$25