Question

Ott Company acquired rights to a patent from Grey under a licensing agreement that required an advance royalty payment when the agreement was signed. Ott remits royalties earned and due under the agreement on October 31 each year. Additionally, on the same date, Ott pays, in advance, estimated royalties for the next year. Ott adjusts prepaid royalties at year-end. Information for the year ended December 31, year 2, is as follows:

Date		Amount
01/01/Y2	Prepaid royalties	$ 65,000
10/31/Y2	Royalty payment (charged to royalty expense)	110,000
12/31/Y2	Year-end credit adjustment to royalty expense	25,000

In its December 31, year 2 balance sheet, Ott should report prepaid royalties of

	$25,000
	$40,000
	$85,000
	$90,000

This Answer is Correct (Answer is D, $90,000)

This answer is correct. On 1/1/Y2, the balance of prepaid royalties was $65,000. Ott makes no entries to this account until year-end, so the 12/31/Y2 balance before adjustment was still $65,000. On 10/31/Y2, Ott made a $110,000 royalty payment which included payment in advance for year 3 royalties. However, under Ott’s system, all such payments are debited to royalty expense when paid, and any necessary adjustments to prepaid royalties are made at year-end. At 12/31/Y2, Ott made a credit adjustment to royalty expense:

Prepaid royalties		25,000
	Royalty expense		25,000

Therefore, the 12/31/Y2 balance of prepaid royalties is $90,000 ($65,000 + $25,000).

Can please explain in a easy way why they add $65,000 of prepaid royalties to the year-end credit adjustment to royalty expense of $25,000 to get prepaid royalties of $90,000 in the December 31, year 2 balance sheet because I don't understand explanation above? Also why don't they use the royalty payment of $110,000 to determine the prepaid royalties in the December 31, year 2 balance sheet?

Answer 1

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