Auditors tend to focus on five issues when auditing royalty related accounts.
Issue 1. Are royalty assets and liabilities reported in accordance with GAAP?
GAAP states that assets should not offset liabilities. This means that unearned royalties (statements with a negative balance) should not be included in royalty’s payable (statements with a positive balance). Why? Including negative royalty payable balances in accounts payable understates your true liability.
- Unearned Royalties: $20,000
- Royalties Payable: $120,000
- Royalties Payable: $100,000
2. Is royalty( rights) income reported in accordance with GAAP?
GAAP and SEC Regulations states that royalty income should be reported net of related royalty expenses. Reporting royalty income (aka Rights income) at gross overstates income. A company that receives $200 in royalty income and owes $50 of this to the author should report $150 as income on their financial statements.
- Royalty Income…. $150 (net of $50 in royalty expense)
- Royalty Income… $200
- Royalty Expense….$50
3. Are royalty assets collectible?
Are royalty advances and unearned liabilities on your books collectable? If not, an allowance account (a contra-asset account) should be established to reduce the value of these assets. You create a contra-asset balance by debiting expense account and credit an allowance account.
Allowance for Unrecoverable Royalties….$100
Balance Sheet: Assets
Royalty Advances ……………………………….$1000
Allowance for Uncollectable Advances.. ($50)
4. Are royalties calculated on all relevant income?
There are many reasons why a company may not calculate royalties on all sales or royalty income. They may have overlooked creating a royalty contract (or royalty rule) for the product, the royalty contract may have been created after the sales were recorded or rights income received may have applied to a general ledger account instead of a product.
During a royalty review the first item on my check list is to look for products not linked to a royalty contract. The second item on my list is tracing randomly selected royalty income items (subsidiary rights income receipts) from the general ledger rights income account to a royalty statement. The third item is looking for sales records on which no royalty expenses were incurred.
5. Are royalties accurately calculated?
Auditors want to confirm that that royalty expenses are calculated in accordance with the terms specified in the contract. If the contract says that no royalties are paid on sales made at below cost were royalties paid on these sales? If royalty rates are based on quantity escalators are the escalators quantities correct? If the contract calls for a lower royalty rate on foreign sales was this rate paid on foreign sales?