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.
Royalty contract examples
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 licensee may withhold a reasonable reserve for returns from customers. The reserve will be withheld for no more than two accounting periods.”
“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.”
General Ledger Example
On June 30 a reserve is withheld from the payment to the author.
General ledger entry
|Royalty Expense||Cost of Sales||$100|
On December 31 the reserve from June 30th is owed (“recovered”) to the author
Some companies report only the net royalty payable as the royalty expense for the period. This is incorrect.
This presentation is incorrect as it:
- Understates the royalty expense,
- Understates liabilities for future payments,
- Overstates income and
- 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.