You can use an inventor’s idea to improve your own operations by entering into a licensing agreement. The licensing agreement gives you the right to use the patented idea for a set period of time. In exchange, you make royalty payments to the inventor as compensation. Royalty payments are treated as prepaid assets on the balance sheet and in your accounting transactions. You must record the advance royalty payment and periodic royalty payments in your accounting system.

Patent Royalty Payments

Royalty payments only apply to your operations that use the patent idea. The operations that do not use the patent idea are accounted for separately. Some licensing agreements require an up-front royalty payment in addition to the periodic payments. The royalty payments can be a percentage of your business net income or calculated on a per unit production basis. Royalties using the net income percentage usually range between 5 and 20 percent. Royalty payments based on the number of units produced fluctuate with your manufacturing operations.

Accounting for Advance Payments

Under your licensing agreement you may have to make an advance royalty payment when you sign the contract. The royalty advance amount you pay is treated as a prepaid expense, since you are paying an expense, which is the right to use the patent, in advance. To record the transaction, you debit Prepaid Royalties and credit Cash. For example, the licensing agreement requires a $50,000 advance royalty payment when you sign the licensing agreement. The journal entry to record the transaction is to debit Prepaid Royalties for $50,000 and credit Cash for $50,000.

Expensing Monthly Payments

At the end of each month you must account for the portion of the advance royalty payment that is due by expensing that amount. You calculate the payment based on the licensing agreement provisions. For example, your advance royalty was $50,000 and your royalty payment is 5 percent of your net income. At the end of the month, calculate your royalties due by multiplying your net income of $60,000 by 5 percent, which is $3,000. To record the payment, debit Royalty Expense for $3,000 and credit Prepaid Royalties for $3,000. The prepaid royalty balance is $50,000 minus $3,000, or $47,000.

Accounting for Terminated Agreements

Early termination fees include penalties for ending the agreement early and a provision to pay part or all of the outstanding royalty fees. Each expense is recognized individually in your accounting system. For example, you pay the inventor a $20,000 early termination fee and $15,000 in outstanding licensing fees for a total of $35,000. You have $8,000 in your prepaid royalty account. To record the early termination costs, debit Royalty Expense for $8,000, debit Loss on Licensing Agreement for $27,000, credit Prepaid Royalties for $8,000 and credit Cash for $27,000. The Loss on Licensing Agreement holds the amount necessary to balance the debits and the credits.