By Kevin F. Howley, CPA
Gray, Gray & Gray, LLP
Royalty payments from the licensing of intellectual property can be a significant source of revenue for a business. But not all licensees keep up to date with their royalty payments, and others may pay a lower amount than required by their agreement. Which is why a royalty audit can be an important tool to protect the income stream from licensed property.
An audit of a licensee’s royalty report serves as an independent calculation of the amount of the revenue the licensee has generated and the portion they must pay to the licensor in the form of a royalty. It is an important financial control that protects the interests of both licensor and licensee. The royalty audit gives the licensor the opportunity to inspect the records and accounts of a licensee to determine whether or not they are paying the correct amount in fees.
Many licensing agreements include a provision that give the licensor an explicit or implied right to determine if royalties are being paid properly. The agreement may also include a provision that stipulates that, if a royalty audit uncovers a certain level of underreporting or underpayment, the licensee must pay the audit fee.
The situations in which a licensor may wish to conduct a royalty audit can vary, as do that events that trigger an audit. For example, if a licensee’s sales are growing robustly, but royalty payments remain flat, this might be a cause for concern. A royalty audit can uncover the reason for the unexpected gap. Another trigger may be expansion into a new market by a licensee without a concurrent increase in royalty payments. Royalty payments that are consistently made late may also be a sign of trouble.
For these reasons, and many others, it is often in the best interest of the licensor to conduct a royalty audit on a regular basis. While a degree of trust must exist between licensor and licensee, the option of a royalty audit serves to keep everybody honest.
How Often to Audit?
Many licensees have an established program to ensure that every licensee, regardless of its royalty history, undergoes a periodic examination of their royalty report. Others include criteria in their license agreements stating that a royalty report that varies significantly from expectations will trigger an audit. Still other licensors only conduct royalty examinations when they spot royalty payment trends that are unexpected, or when they notice possible discrepancies in royalty reporting.
Licensors who perform royalty audits only when a discrepancy occurs take a big risk. Without the benefit of a history of periodic royalty examinations they cannot be sure if the royalties have ever been calculated in accordance with the license agreement.
We recommend an audit be done at least every two years in order to make sure licensing agreements are being met and royalty requirements fulfilled. It also puts the licensee on notice that their books will be closely examined, which may help deter any attempt to underreport sale in order to reduce payments.
Factors Influencing Royalty Fluctuations
A good auditor knows that every royalty examination is unique. The figures conveyed in a royalty report may have been influenced by a number of factors, from special clauses in a license agreement, to current economic conditions in the licensee’s market. Examination procedures should be designed and agreed upon in advance, and the fieldwork phase should identify and quantify special circumstances that may have an effect on the report.
Findings of the royalty audit should be assembled quickly, and any discrepancies identified and quantified in detail. We have seen royalty audits that resulted in the need for additional payments from a licensee who understated royalties owed, but also refunds made by the licensor when it is found that a licensee has overstated their obligation. The key thing is to resolve the situation promptly so the relationship may move forward.
Independence is Essential
While you may be tempted to rely on your own accounting staff to conduct a royalty audit, that may lead to the perception that the results will be biased. Remember that, after the audit the relationship between licensor and licensee will continue, so a level of trust must be maintained.
That is why an independent outside auditor is the preferred method to reassure both licensor and licensee that accurate and objective results will be obtained. An audit firm with the right experience will know what to look for in a license agreement, and will be quick to identify and quantify variances and discrepancies in the royalty reports. The third-party objectivity that an independent auditor brings can reduce the level of stress surrounding the royalty audit, which results in the process becoming more consultative than confrontational.
Kevin F. Howley is a certified public accountant with more than 25 years of auditing experience and specializes in Royalty Examinations. He is a Partner in the firm of Gray, Gray & Gray, LLP in Canton, Mass. He can be contacted at khowley@gggcpas.com or (781) 407-0300.